Green Doesn’t Always Mean Lean Returns

This is part II on low carbon investing, an exploration by Emma Cusworth on how green ETFs don't have to mean low returns. Part I is about how institutional investors are using their might to create low carbon opportunities for investors of all sizes, and can be read here.

As the pressure mounts on countries to cut carbon emissions, there is growing evidence that low carbon investing can outperform in contrast to the widely-held perception of environmentally friendly investment performance.

The move to a low carbon economy continues to gather pace. The objective for this year’s United Nations Climate Change Conference, to be held in Paris in November and December, is to reach a legally binding and universal agreement on dealing with climate change globally.

The growing pressure to deal with climate change presents risks for investors regarding the concept of ‘stranded assets’: should a legally binding agreement limiting carbon emissions be reached in an effort to cap global warning to two degrees centigrade, up to 80 percent of known reserves held by publically listed fossil fuel extraction companies would no longer be viable, significantly impacting those companies’ share price growth in the future.

However, in the ETF space, the number of low carbon offerings are not only limited, they suffer from a perception of underperformance.

No Compromise On Performance

According to ETFGI partner and co-founder, Deborah Fuhr, low carbon ETFs, like many in the environment, social and corporate governance (ESG) category, face a significant challenge in their ability to accrue assets.

“There is a big question about the performance of ESG indexes relative to cap-weighted indexes,” she said. “The perception is that being altruistic means giving up some degree of performance.”

However, there is growing evidence that this may not be the case. The limited number of low carbon ETFs available to European investors have demonstrated an ability to outperform traditional indexes.

The MSCI World Low Carbon Leaders Index has outperformed its parent index, the MSCI World. Figures to the end of July show the two indexes produced annualised returns of 13.81 percent and 13.45 percent respectively since 30 November 2010. Over three years the outperformance is more marked with the Low Carbon Leaders Index clocking 17.69 percent annualised returns versus 16.98 percent for the MSCI World.

Amundi launched an ETF tracking this benchmark in May, the Amundi MSCI World Low Carbon UCITS ETF (ticker LWCR in euro or LWCU in USD).

Good Returns Continue

Evidence from Europe’s longer-standing low carbon ETF, the Low Carbon 100 Europe Theam Easy UCITS ETF, supports this. The ETF tracks the LC 100 Europe index, which gained 12.33 percent in the year to 30 June, versus the FTSEurofirst 100 Index’s 8.46 percent.

The low carbon index recorded gains of 3.69 percent in 2014, 20.29 percent in 2013 and 12.38 percent in 2012. By contrast, the FTSEurofirst 100 Index returned 1.8 percent in 2014 and 15.14 percent in 2013. Interestingly, both indexes were down in the second quarter of this year, but the low carbon approach fared much better. The FTSEurofirst 100 fell 5.17 percent while the LC 100 Europe index was down 3.06 percent.

Hidden Potential For Low Carbon?

The potential for outperformance of low carbon indexing could be significantly greater than the MSCI World Low Carbon Leaders Index suggests because this MSCI index was designed from a risk management rather than opportunistic point of view, limiting its ability to outperform.

Thomas Kuh, executive director of ESG indexes at MSCI, said: “MSCI’s low carbon indexes are designed to protect against the potential risk of carbon exposure more than to capitalise on the transition to a low carbon economy.”

The MSCI World Low Carbon Leaders index is designed to track the MSCI World index closely and has done so with a realised tracking error of about 50 basis points, according to Kuh. “The trend has been for the MSCI World Low Carbon Leaders index to outperform the MSCI World,” he said.