The way investors can (and want to) access all asset classes evolves over time – the first UK equity funds were the loadstar for the creation of smaller, company, and income mandates. 

Then came the creation of funds that were designed to provide exposure to particular factors within an economy, such as value or growth. 

Hugo Machin, co-head global listed real assets at Schoders, says property investors have also been moving to future-proof their exposures, with buildings that have higher environmental standards, or which are a more pleasant experience for employees now having a premium valuation attached to them relative to more traditional buildings.

The evolution of the responsible investing landscape has been cruder, with the initial wave of funds being focused on excluding certain sectors, such as tobacco or weapons. Then came funds that were badged as sustainable, and had a focus on environmental factors, but were often viewed by market participants as leaving their clients overly exposed to the growth style of investing. 

This, says Sam Whitehead, head of ESG ETF product management for EMEA at Invesco, says the challenge for those bringing products to market now is that “for a while, clients associated responsible investing products with alpha, with outperformance. But since 2022 that has gone away, and the next thing is clients want a product they can easily understand. They find the usual ESG labels hard to digest.”

He says this desire from clients for products that have very clearly defined goals has boosted demand for climate-related products, where the aspirations of the fund manager are easier to articulate than are the goals of a fund manager who runs a social investment fund.

Whitehead says he believes this is what has driven the demand for environmental funds and hindered demand for social funds in recent years.

Robert Bluhm, head of sustainability at Universal Investment Group, says: "Sustainable investments are witnessing the emergence of new themes beyond renewable energy. Developments include a focus on health and demographic changes, with an increasing emphasis on healthcare solutions. Social aspects, particularly robust corporate social responsibility practices, are gaining relevance.

"Additionally, there is a shift towards diversification, encompassing sub-sets like carbon capture. Some alternative funds are evolving with a focus on technological solutions, reflecting a comprehensive approach to sustainability. Water resources continue to be a key consideration, with evolving strategies addressing issues such as scarcity and pollution."

One individual seeking to change the narrative around social investment funds is Obe Ejikeme, a fund manager who, among other things, runs a social bond fund at Carmignac.

He says one of the ways innovation is being driven in this part of the market is “the greater availability of data. It was this lack of data which probably hindered the development of social impact funds in the past.

"In terms of how we explain it to clients, we say, 'social impact funds are about how a business impacts its people' – and by its people we mean the employees and the customers. There is now huge amounts of data available which was not the case in the past.”

Whitehead says one of the ways in which the market is seeking to address the issues around social funds is through the development of products that invest in areas such as biodiversity, which can be both social and environmental in nature, in a way that is easy to explain to clients. 

Even within the environmental space, there has been some expansion in terms of themes, according to Jon Forster, who co-manages Impax Asset Management's specialists and climate strategies.

He notes when he began working on the trust, its investment universe centred on three key themes, but this has now grown to six. Among the new themes to have entered his portfolio in recent years are the circular economy and what he calls "smart environment".

He says the smart environment theme enables investors to own companies that, for example, produce software that enables more traditional climate-focused sectors. 

Forster says the circular economy theme is focused around more efficient production methods, and also on more environmentally friendly waste management.

He told FT Adviser that his investment process involves initially selecting from a universe of companies that generate more than 50 per cent of revenue from environmental factors, and then those that also fit within the themes are placed onto an A list of stocks that are eligible for inclusion in the portfolio.

At that point, analysts whose role is to examine purely the investment case for each of the stocks on the A list, and at this point its narrowed down to a portfolio.

Thinking about diversification

On the topic of diversification, apart from the thematic diversification he mentions above, Forster says: “While its definitely the case that one is exposed to the growth factor when investing in the way we do, there are many more opportunities for diversification than was the case in the past.

"When we launched this strategy in 2012, the sector was dominated by energy companies and by companies that were reliant on subsidies, and so it was quite volatile. But now its possible to invest in a broader range of companies and also in companies that are profitable in their own right – if we own a loss maker now, its very much an outlier in the fund."

Whitehead acknowledges that attempting diversification within a responsible investment portfolio is hampered, as one almost inevitably ends up owning growth stocks.

This is a point taken up by Callum Wells, co-manager of the Castlefield sustainable portfolio range, who says: “It’s well known that responsible investment portfolios tend to contain several distinct style biases (principally toward growth and quality, and as a consequence the distant nature of many of their cash flows, a strong sensitivity to changes in interest rates).

"Often these factor risks are accepted, sometimes even desired, but the role of the portfolio manager is to control the levels of factor risk within portfolios. Where responsible investment portfolios exhibit an undesirable level or composition of factor risks, it then becomes the manager’s responsibility to bring this back to more intentional levels.

"In many ways, effective diversification within responsible investment portfolios is no different to effective diversification within their unconstrained counterparts."

Whitehead says if one wants a diversified portfolio, “you really have to go into small caps, which is tricky. But on the other hand, if you buy passives, which can be diversified, the issue is that they are likely to be thematic products.

"Research shows that thematic funds underperform in the first year, as there is a bunch of hype, which is why the product launches, but between the hype and the launch, there is a gap of a few months, and sometimes the hype has dissipated."

He notes that diversification can best be achieved through investing in the “industries adjacent to the big themes. So for example, in the energy space, instead of just owning the renewable energy stocks, one can own the energy storage and battery makers.”

Whitehead adds that evolution in both the regulatory and the economic sense has also aided diversification, with the EU’s official taxonomy allowing nuclear energy investments to count as sustainable, “while solar energy is quite well established and there are lots of mature companies in the space.” 

But while he feels the regulatory classification of nuclear energy may have helped with the diverisificaton conundrum, he says: “Generally speaking the launch of thematic-focused products is lower as a result of the regulatory requirement to ‘do no harm’, as it reduces the pure play element of a thematic fund, it has to take into consideration a broader number of elements. And the major advantage of a thematic fund is that its a pure way of investing in a responsible investing part of the market. And being pure play it’s easy for the client to understand it.”  

Wells says that while regulation inevitably impacts portfolio construction, he feels the market comes up with the fresh themes and product ideas, which the regulator then responds to. 

Universal Investment's Bluhm says that when considering diversification one should have a series of “sub themes” within the broader portfolio, rather than on big picture thematic ideas, as there may be correlation between those.

He adds that geographic diversification is also an important consideration. 

Ejikeme’s attempt to create a social investment product that can be backed by data, rather than just individuals' subjective view on the construction of society, has led him to focus on customer and staff satisfaction data, plus data as reported by companies. 

He says that allocating capital to companies which treat people in a way that might be considered fair “has the potential to help 2bn people on the planet, and there are few other ways of investing that can achieve that.”

Ejikeme says: “Just as greenwashing is a problem for those investing with the environment in mind, so social washing is a problem. For example, a weapons manufacturer may be a great place to work, but it still could not feature in a social impact fund.

"And customer satisfaction scores are very unlikely to be high within the banking sector, despite it potentially being a great place to work. So we use three data sets: customer and employee surveys, news flow about a company and also what a company says about itself. We give equal weighting to the survey data and a lower weighting to what a company says about itself."

He adds that each company is then given a numerical score, with the top 30 per cent deemed potentially investible. 

Ejikeme says if a company drops out of the top 30 per cent for two consecutive months it must be sold. 

Responsible investing funds have endured a couple of years of relative underperformance and, more recently, outflows have started to bite, but the sector, in common with the evolution of other asset classes, is likely to have many further iterations in the years ahead.  

David Thorpe is investment editor at FT Adviser