Diversifying risk from mainstream responsible investing through venture capital

While environmental activists here in the UK targeted bank headquarters in protest at the continued investment in fossil fuels and the world’s leaders debated the climate crisis at the Cop 27 UN summit in Egypt, it is clear that urgent action is needed.

While the world waits for leaders to agree on a path forward, investors can help today by using their capital by funding more sustainable companies. The investment management industry is now awash with new funds that incorporate ESG (environmental, social and governance) considerations into their investment objectives.

Globally, fund assets that are classified as being sustainable stood at USD 2.47 trillion as at the end of `June 2022, according to Morningstar’s report entitled Global Sustainable Fund Flows: Q2 2022 in Review, which also showed that 245 new ESG-focused investment funds were launched in the second quarter of the year (see Reuters for more details).

This proliferation of investment vehicles that seek to meet the growing demand from investors for ethical homes for their capital-including funds that have explicit climate change-mitigation approaches that go further than mere ESG consideration when selecting companies - has created a wide variety of responsible investment vehicles for investors’ capital.

However, this proliferation of available vehicles from the familiar investment fund houses in the open-ended investment industry belies the fact that there are often just a handful of popular holdings across many of these mutual funds. Investing across a number of different-sounding investment funds could, when looking at the underlying holdings, mean exposure to the same handful of companies. In a report entitled The Top 20 Largest ESG Funds–Under the Hood, published by MSCI ESG Research LLC last year, the largest ESG product shad a number of mega-cap technology and communications stocks in common, such as Microsoft, Apple, Comcast and Verizon.

Popular common holdings across a number of UK sustainable funds include familiar pharma companies AstraZeneca and GlaxoSmithKline, publisher RELX, consumer goods company Unilever, and insurers Legal & General and Prudential. Investors Chronicle, 23 November 2021 (https://www.investorschronicle.co.uk/tips-ideas/2020/12/02/esg-fund-managers-favourite-uk-shares/)

While these are indeed highly successful companies, they are arguably both mature and operate in just a handful of industries - not traditionally considered either a good growth or diversification strategy.

Investors should also bear in mind that a number of these holdings are constituents in standard market indices. The companies named above are all in the FTSE 100 index of the hundred largest companies by market capitalisation. This means that in the event of a significant stock market selloff, one’s invested capital could experience a potentially unexpected fall in value because, as the well-known stock market indices sell off, the companies in each index are likely to experience selling pressure on their shares, including the holdings in an open-ended SRI fund.

Venture Capital helps to offer a solution to both these investing concerns.

1. Firstly, the types of firms that are seeking VC funding are at a very different stage in their maturity cycle than established, listed companies. This offers a quite different profile to many standard market indices and their constituent companies.
2. Secondly, the types of businesses on offer are innovative and often operating in fledgling areas of the market, thereby providing an excitingly different proposition for investors. Both of these characteristics offer highly appealing diversification properties for investors who already hold assets with a traditional active manager or through passive exposure via an exchange-traded fund.

With many listed equity markets around the world appearing fully valued, and with little yield on offer from bonds, venture capital can offer both diversification from traditional markets and investment approaches - even those with an ESG lens or explicit climate-related objective - as well as exposure to exciting firms engaged in innovative technologies that are helping to mitigate climate change right now.

If they can receive additional funding, portfolio firms in a VC vehicle can scale up to provide meaningful solutions to the problems the world faces while offering patient investors attractive rates of returns in the medium to long term.

At the same time, the longer-term nature of VC investing can provide a valuable bulwark in a broader investment portfolio against the short-term volatility that is inherent in almost all publicly listed equity investments.

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Written by Dr Lisa Smith, Managing Director