Sustainability and the behaviour gap

Yesterday, I wrote about the fact that a majority of US retail investors are giving significant weight to the sustainability of their investments when given a choice. Now, there is some evidence that sustainable investments might also improve the performance of retail investor portfolios, though not in the way that many readers might expect. The discussion about the “advantage” of sustainable investments over traditional investments typically centres around the question as to whether sustainable investments have higher returns and/or lower risks. But a recent study by Centered Wealth, a financial advice firm from Minneapolis showed that the advantage of sustainable investments may be in the way they discipline investor behaviour.

The famous behaviour gap has been well documented over time. The behaviour gap measures the difference in performance over an extended time period (typically ten years) between a hypothetical investor in a mutual fund or ETF and the actual average return investors in that fund achieved. Because both institutional investors and private investors tend to sell funds at the wrong time (i.e. after a market decline) and chase past performance when buying into funds the performance of the average investor in a fund is significantly below the hypothetical performance of a long-term buy and hold investor in that fund. Retail investors lose on average 1.8% per year due to ill-timed sales and purchases of funds while institutional investors lose a more moderate 1.2% per year. Nevertheless, the data shows that the timing decisions of both retail and institutional investors reduces performance more than the management fee per year – something to reflect on for all our readers.

In comparison to the average behaviour gap for all investors, investors in impact funds, managed with sustainability criteria as one of the main drivers of the investment process, had a much lower behaviour gap of c. 0.9% per year. This was the lowest behaviour gap observed in the study except for index fund investments. And intuitively this makes sense. Because sustainable investments are made with a broader set of goals than pure return optimisation, investors are willing to stick with sustainable and impact funds for a longer time when markets become volatile and uncertain. This means that these funds have a better chance of surviving in an investor’s portfolio until a recovery sets in. It is this lower probability for investors to “abandon ship” in a rough market that drives the better performance of sustainable investments in a portfolio. 

Though this is only one study and more work needs to be done, this research indicates that sustainable investments may be beneficial for both investors and advisers. For investors because their effective returns in the long run might improve and for advisers because they have an easier time helping their clients stay the course for the long run and not sell at the worst possible time.

Source: Centered Wealth.