It’s an issue of over-concentration.
Too many sustainable funds are taking too narrow a focus on stocks in headline sectors. But when these sectors enter periods of volatility – like every area of the market does – investors are left over-exposed, suffering particularly significant drawdowns.
It needn’t be this way. Proper diversification into quality companies across the entire sustainable universe can provide both long-term returns and consistency on the journey.
The risk of overexposure
One area of particular over-concentration in the sustainable investment universe is clean energy.
Stocks supporting the shift towards areas like solar power, wind power, hydrogen energy, and electric vehicles (EVs) are essential to meeting global climate goals. However, after a sustained period of exuberance, many have suffered enduring weakness since 2022.
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There are numerous reasons. But the most significant have probably been increasing rates – which has made borrowing more expensive – and greater competition from China – which has driven prices lower.
The overall effect has been stagnation across a number of key clean energy sectors. Valuations have declined in the face of sky-high investor expectations. Strategies with significant allocations have seen performance suffer.
Diversify for downside protection
We’re not saying investors should avoid clean energy sectors; far from it.
With many countries phasing out fossil fuels completely and the adoption of EVs and solar power on track to multiply, the future market for these areas is large. Quality names will thrive over the long term.
The point is, clean energy stocks are unlikely to increase in a straight line, as recent volatility has demonstrated. Long periods of underperformance will no doubt be a problem for investors wanting to access their capital.
This is where proper diversification is powerful. Balancing a clean energy allocation with positions in other, uncorrelated areas of the sustainable investment universe offers key downside protection.
Companies focused on areas like energy efficiency, water protection, the circular economy, and biodiversity restoration all contribute to global sustainability goals. They also offer huge long-term growth potential.
But their performance is not necessarily highly correlated to that of clean energy as a whole. These names won’t necessarily suffer from volatility because stocks in areas like solar power and EVs are – and vice versa.
Because of this, allocating across the entire sustainable universe rather than focusing too heavily on just one theme allows investors to participate in the upside on offer while minimising volatility on the journey.
Quality AND quantity
That’s not to say it’s enough to just invest in everything sustainable. To generate strong and stable returns, a focus on diversification must be paired with a focus on quality.
We only allocate to stocks once we’re confident they present a range of characteristics maximising their chances of being long-term sector leaders.
These include a strong balance sheet, an experienced leadership team, and – perhaps most importantly – a powerful competitive moat. This means a sustainable advantage over competitors that lends itself to a leading market position and profitability over time.
Excellent examples can be found in the heating sector.
Traditional gas boilers are being phased out in favour of heat pumps, which offer far greater efficiency. However, gas lobbies worldwide are advocating for hydrogen as a replacement – even though it remains significantly less cost-competitive. To be clear, hydrogen does have potential in certain applications, but its viability today is limited. The hydrogen ladder from Michael Liebreich of the Cleaning Up podcast illustrates where it makes the most sense.
As such, our investment strategy side-steps investment moonshots like hydrogen for domestic heating.
This is just one example.
Other examples are carbon capture and storage for power plants, solar roads, e-fuels for cars, compressed air energy storage and algae-based biofuels.
But it emphasises the point that, even in emerging sectors like those in the sustainability universe, bottom-up analysis ensures exposure to only the most prospective stocks.
Strong and stable sustainable returns
We believe stocks solving the many environmental challenges we face today present some of the best long-term investment opportunities in the market. The key to capturing this trend, however, is to not put all one’s eggs in one basket.
Investing in quality names across a range of uncorrelated environmental sectors can offer investors the best of both worlds – long-term returns with a cap volatility on the way.
Rahul Bhushan is managing director at Ark Invest Europe
