UK sustainability: Weathering the headwinds

The landscape for sustainable investments in the UK equity sector has been extremely challenging in recent years with investment houses having to cope with large net outflows, navigating the SDR labelling regime, a poorly received COP30, the threat from passives, fund underperformance and the rising geopolitical tensions in Europe & now the Middle East.

UK equity: Net outflows continue

The UK equity market has been out of favour for some time with the US via the magnificent seven taking the lead in terms of inflows. The Investment Association estimates that a total of over £70bn was pulled by retail investors from UK equity funds in the past decade, with each year being negative. Despite UK equity indices delivering strong returns over the past two years, the outflows remain deeply concerning. The volatile political landscape in the UK isn’t helpful, with multiple Prime Ministers and Chancellors trying unsuccessfully to reboot the economy and financial markets.

SDR: Underwhelming and confusing

The introduction of a new labelling regime by the FCA has dealt the sector another hurdle to overcome and the dismal uptake is evidenced by only 106 funds signing up for an UK SDR label, out of a possible universe of approximately 5500 funds. Several notable investment houses have opted not to adopt a label, choosing to remove Fund references to sustainability instead. This has left a confusing market for investors and the absence of an ethical label is surprising, more so given that ethical funds were the foundation of the sustainable investment industry.

The new fund labels which include responsible, sustainable, impact, and stewardship are confusing more so when the top 10 holdings include names that were traditionally excluded on ethical grounds – tobacco, mining, alcohol and oil & gas. The debate on including defence companies has heated up with many sustainable funds pressing the patriotic button in the hope of relaxing the criteria for including investment in the sector on the back of the conflict in Ukraine.

Passives: Dominating

The exponential growth in passive funds has not only increased the choice for investors, but added continued downward pressure on fees. An analysis via Citywire shows there are approximately 50 passive funds in the top 100 performing funds available in the UK equity sector over one, three, five and 10 years. Investors now have the choice of index funds, ETFs and active ETFs, all offering a low-cost solution, and this will only continue to add pressure on active funds. In terms of performance, passive funds are well placed in the top quartile across one, three, five and 10 years. For the latter two time periods, passive funds dominate at the top decile level, illustrating the challenge for active managers in the UK equity sector.

Performance: Underdelivering

The sustainable sector enjoyed a golden period up to 2022 where proponents could confidently state that sustainability was a driver of returns and outperformance. Ever since the launch of the first ethical funds in the late 1980s in the UK, the accusation levelled at the industry was that returns had to be sacrificed for ethics.

However, the last few years have been extremely difficult in terms of performance for UK sustainability funds. In terms of first quartile performance, only three sustainable funds appear over one year, two funds over three years, none over five years and one solitary entry over 10 years, which put the accusation front and centre once again.

The argument that sustainable investment can provide both financial and social and environmental outperformance has been shaken by conflict in Europe and the Middle East. This has led to sectors such as tobacco, mining, defence and oil & gas, naturally excluded by UK sustainable funds, outperforming creating a meaningful divergence versus non-screened UK funds.

The danger is that level of underperformance by UK active sustainability funds may take years and even decades to reverse, more so given the threat from passive solutions. The next generation of UK investors are likely to focus on a low fee approach to portfolio management, which delivers on outperformance and their values.

Outlook

The outlook for UK sustainable funds remains uncertain with headwinds set to only increase in the short and medium term. If the sector goes down the route of easing restrictions on defence and other industries which have been traditionally excluded, there is a danger of going beyond greenwashing, an accusation the sector has been fighting off vigorously.

For investors, the lack of choice of funds is ever present, with fund closures, fund relabelling and fund house consolidation continuing apace. Will there be a place in the wider industry for specialist sustainable investment houses, or will these be swallowed up by larger generalist houses?

The failure of COP30 has hurt momentum for sustainability as has the confusion over SDR labelling. Since then, RI, SRI, responsible, green, environment, ESG, climate, sustainable, stewardship and impact have entered the lexicon. The ESG backlash is real and worryingly persistent and no amount of hopeful rhetoric will immediately dampen the strong headwinds facing the sector.

However, there will continue to be a large pool of investors with ‘patient capital’ convinced the transition is real, and wanting to invest in line with their ethical and climate-based values. The sector may therefore retrench and recalibrate, but it is likely to be around long after the MAGA movement has disappeared.