M&G UK Sustain Paris Aligned Fund: Q4 Report & 2022 Summary

10 min read 18 Jan 23

The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise. There is no guarantee that the fund will achieve its objective, and you may get back less than you originally invested. The fund can be exposed to different currencies. Movements in currency exchange rates may adversely affect the value of your investment.

UK Sustain Paris Aligned: A new beginning

For the fund, the highlight of 2022 was the July transition to becoming the M&G UK Sustain Paris Aligned Fund. Over the last few years we’ve been on a gradual journey to integrate sustainability as a core pillar within our investment philosophy. The conversion marks the culmination of that journey, which sought to fully align the fund and its investments with society’s quest to achieve net-zero carbon emissions by 2050, as set out in the 2015 Paris Agreement.

Paris-aligned funds are a nascent concept, predominantly associated so far with passive investing. In converting the fund we’ve created something we believe is unique: a concentrated active UK fund that combines bottom-up stock picking and engagement with overall portfolio decarbonisation aligned to the net zero target. We are yet to find a direct peer that offers those characteristics.  ‘Being unique’ is only desired if it brings other benefits; we think there are multiple. Firstly, it’s our moral responsibility as stewards of our clients’ savings to allocate capital in companies aligned to the net zero carbon goal. Secondly, over the long term we think this will yield positive investment returns as profit pools shift to companies that are favourably exposed to decarbonisation. We’re excited for the future of sustainable investing, and we hope you share our optimism.

Sustainability: A generationally significant year

In many ways, 2022 was a year of ‘re-carbonisation’ and the admission of our vulnerability to fossil fuels. It may also prove to be the greatest long-term catalyst to de-carbonisation we have ever witnessed. Energy security and supply shortages became critical political and economic issues. We saw energy switching towards coal and oil in a way previously deemed irrational and contrary to anti-climate change rhetoric. There is no doubt that 2022 represented a step up in global carbon emissions. However, it may turn out to be pivotal in accelerating our march towards net zero:

  1. Behaviour – Industrial, commercial and consumer behaviour adapted to high energy prices to a far greater extent than the market anticipated. We have become more aware of our energy usage and how efficiently we use it. Even if energy prices fall, I think this appreciation of efficiency and behaviour towards limiting our footprint will be entrenched. 
  2. Domestic supply – Our reliance on a handful of countries rich in fossil fuel was fully exposed. Governments now understand the importance of domestic production and self-reliance. This can only be achieved -- in countries that do not possess resource deposits -- by significantly increasing renewable energy production. 
  3. Policy support – Both the US ‘Inflation Reduction Act’ (IRA) and REPowerEU are generationally significant advances in climate policy and support. The IRA alone will direct nearly US$400bn to clean energy initiatives. The tax incentives, grants and loan guarantees in place make investment in clean projects an economic slam-dunk versus fossil-fuels. Global policy support for decarbonisation is compelling and undeniably material.

Performance: A tough year for sustainable investing

There is no hiding from it: 2022 was the ‘annus horribilis’ for sustainable investing, especially within the UK. Various factors combined to create the perfect storm of market behaviour that negatively impacted fund performance. The UK Sustain Paris Aligned Fund did not escape that wrath. 

Figure 1. UK Inflation and 10yr Bond Yield (%)

Source: Factset, as at 31 December 2022

Inflation, already running hot through 2021 due to rampant demand recovery, labour shortages and supply constraints, continued to intensify through the year. Russia’s invasion of Ukraine in February 2022 threw fuel on the inflationary fire, especially within energy and agricultural markets. These pressures sent seismic shocks through global supply chains. Meanwhile, in major developed economies, labour markets continued to tighten through the year, with US unemployment hitting lows of 3.5%1. As commodity prices eased in the latter part of the year, wages took over as the principal driver of inflation. In the UK, where the combined factors are perhaps most acute, Retail Price Inflation topped an almost unimaginable 14%2. Monetary policy had to play rapid catch-up. At the start of 2022 the US base-rate remained at zero, with markets pricing in for the Fed to never get beyond 1%. By year-end the US interest rate stood at 4.25-4.5%, with the Fed median dot plot suggesting a peak of 5.125%3.

This drastic monetary tightening reversed 12+ years of declining rates and quantitative easing that followed the global financial crisis. Accordingly, the US 10-year Treasury yield, a proxy for the risk-free-rate, hit 4.22%4, a level last seen in mid-2008. As the implied risk-free rate rose we saw a fundamental re-pricing of financial and real-world assets. Everything from bonds to equities to property and even crypto felt the pain. The only areas that escaped the fury were those linked to energy, defence and commodity markets, boosted by the war in Ukraine. Within equities, leadership continued to come from ‘value’-oriented stocks, away from ‘quality/growth’ where the risk-free rate forms a greater determinant of future value.

Figure 2. ‘Brown’ and ‘sin’ sector return

Source: Factset, as at 30 December 2022

Past performance is not a guide to future performance.

Figure 3. FTSE returns (%), 2022

Source: Factset, as at 30 December 2022

Nowhere was this more visible than in the FTSE. The top-end of the FTSE is very much ‘value’ oriented, with an exceptionally high proportion of legacy businesses within commodities, finance, tobacco, utilities and defence. With the exception of finance, these sectors are not typically associated with sustainable investing. Quite to the contrary: energy, tobacco, defence, utilities and basic materials are either very difficult or impossible to invest in under the framework of a Paris-aligned fund like ours. Most are formal exclusions. The rest are highly carbon-intensive and rarely have formalised net-zero pathways, whilst also treading on the European Union’s Sustainable Finance Disclosure Regulation (SFDR) boundary of ‘do no significant harm’. They also happened to be the sectors that saw positive returns during 2022.

You can clearly see how positive returns in these ‘brown’ and ‘sin’ sectors shaped performance across the spectrum of the FTSE. FTSE Value returned nearly 9%, and the FTSE 100 delivered 5%. This contrasts enormously with the FTSE 250 at -17.4% and AIM at a shocking -30.6%1. Not owning these brown and sin stocks was an unavoidable 6.7% headwind to performance. Commodities in particular are prone to occasional bouts of volatile performance, but over the longer term they have been serial destroyers of capital. This isn’t the first time they’ve done this and it probably won’t be the last. We can’t shy away from how difficult performance was for the fund during 2022, but we do think it was a very exceptional year. Exceptional in regards to both the war and the intensity at which the monetary paradigm inflected. These factors shaped the market’s behaviour in a way that made life immensely difficult for a UK sustainable fund that invests in high-quality compounders.

Outlook

What will this year hold? A macroeconomic prediction is a proverbial finger in the air to call the market’s directional gusts. Calling 2023 feels like putting your finger in the air whilst stood in a hurricane. I think the outlook for 2023 will pivot on the direction and magnitude of three dynamics, with the net result being anything between a hard landing and no landing at all:

  1. Inflation is likely to have peaked, but how far and how fast it declines will dictate monetary policy and subsequent behaviour of financial markets. Wage inflation feels like the last piece of the puzzle in allowing it to ease towards the Fed’s 2% target. We probably need to see some unemployment to facilitate that. If wage pressures persist, then monetary policy may remain dangerously restrictive. Overtightening due to the lag in monetary policy hitting the economy is an issue that has haunted central banks historically. The inversion of the yield curve implies repetition of that recession-inducing mistake. We’re definitely seeing worrying cracks in isolated end-markets such as property, construction and tech hiring, but the wider economies seem remarkably resilient so far.
  2. The war in Ukraine is an obvious 2023 variable. Any resolution should allow further energy and agriculture-related easing. It feels like only Vladimir Putin could give the answer to that unknown.
  3. China’s big-bang reopening from its restrictive ‘zero-COVID policy’ is a fascinating narrative. How hard the Chinese authorities push on the stimulus pedal will have global ramifications.

What about sustainable investing? The good news is that 2022 was hopefully the exception rather than the rule, as explained earlier. As inflation recedes towards a new norm, and monetary policy settles alongside, so the rotational forces that have shaped performance should dissipate. We remain firm believers that over time the theory of compounding of wealth creation will hold true, bringing positive investment returns. We also believe that sustainability and de-carbonisation sit at the heart of that, accelerating the forces of empowerment and disruption as we move towards a net-zero carbon society. 2022 was a tough hurdle to pass, but it may just turn out to be a blessing in disguise in magnifying the importance and return potential of the UK Sustain Paris Aligned Fund. 

Fund performance

Quarterly performance (%)

    Q4 2022 YTD 2022
Fund 8.9 -14.4
Benchmark  8.9   0.3 

Calendar year performance, five years (%pa)

    2021 2020 2019 2018 2017
Fund 7.6 4.1 21.9 -11.1 14.8
Benchmark 18.3 -9.8 19.2 -9.5 13.1

Past performance is not a guide to future performance.

Benchmark = FTSE All-Share Index

The benchmark is the target for the fund’s financial objective and is used to measure the fund’s financial performance. The index has been chosen as the fund’s benchmark as it best reflects the scope of the fund’s investment policy.

The benchmark is also used to define a Low Carbon Intensity Company. The fund manager considers the fund’s weighted average carbon intensity against the benchmark when constructing the portfolio, but the benchmark does not otherwise constrain portfolio construction.

The fund is actively managed and within given constraints, the fund manager has freedom in choosing which investments to buy, hold and sell in the fund. The fund’s holdings may deviate significantly from the benchmark’s constituents and as a result the fund’s performance may deviate materially from the benchmark.

The fund changed its name, investment objective and investment strategy on 13 July 2022. Prior to this date, the fund was named M&G UK Select Fund. Fund performance before this date was therefore achieved under different circumstances.

Source: Morningstar, Inc., as at 31 December 2022, GBP Class I Acc shares, income reinvested, price-to-price basis. Benchmark returns stated in share class currency.

Please note that the fund invests mainly in company shares and is therefore likely to experience larger price fluctuations than funds that invest in bonds and/or cash.

Further risks associated with this fund can be found in the fund’s Key Investor Information Document.

1 Source: US Bureau of Labor Statistics, Trading Economics, January 2023
2 Source: ONS, Factset, December 2022
3 Source: Bloomberg, January 2023
4 Source: Bloomberg, October 2022
5 Source: Factset, as at 31 December 2022

By Rory Alexander

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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