Both exclusion and inclusion criteria play a key role

Equity indices are primarily built by considering the market capitalisation of a company, with the largest companies standing for the largest weightings within those indices. Over the past decades, several of the most successful and fastest growing companies have also been some of the most controversial.

A good example of this are tobacco companies such as British American Tobacco or Philip Morris, or oil & gas majors including BP and Exxon. Each of these benefitted from a lack of accountability from consumers, investors and regulators when it came to their negative externalities

Indeed, from a sustainability standpoint, we know that more than 8 million people die from tobacco use every year and oil and gas companies represent 45% of human produced greenhouse gas (GHG) emissions contributing significantly to climate change as a result. Despite marketing campaigns promoting their sustainability ambitions, these businesses present key hurdles to meet the UN Sustainable Development Goals by 2030 and our 2050 net zero targets. As a result, they do not feature in the EQ Positive Impact, Future Leaders or Climate Action portfolios.

Meanwhile, businesses that are providing solutions through their core products and services to the many social and environmental challenges we face tend to be of smaller size. Usually, smaller size companies are more agile, with a focus on innovation and as a result are key enablers to help solve those challenges. These are profitable companies that tend to reinvest their profits into developing new solutions instead of paying large dividends or financing share buybacks.

Focusing on operational sustainability including social, environmental and governance factors, also called ESG, leaders can be found across both small and large size businesses. However, several mega cap companies such as Meta or Berkshire Hathaway are seen as laggards within their peer group.

So, an ambitious and diversified sustainability approach embedding both negative and positive screens is highly likely to allocate a higher proportion to smaller size companies than unscreened global equity indices.

It can create short term challenges…

As we know over the long term, financial markets reward companies that are consistently increasing their profits year after year. In the short term however, financial markets can be driven by positive narrative and/or future hype but more uncertain long term financial outcomes.

A perfect example is the recent experience with the Magnificent 7. The valuation of those seven companies is now double that of the global small cap universe despite similar earnings growth expected in 2025. So, we believe it is a strong reason to be more optimistic about the future of smaller size companies as investors will be looking to the next growth areas while being mindful of valuations.

The second challenge is that smaller size companies tend to be more sensitive to interest rate changes. A significant rise in interest rates, such as the one we experienced in 2022 and 2023, is likely to lead smaller size companies to underperform larger size companies. But equally, a period of decreasing interest rates or with low interest rates is likely to be more supportive of smaller size companies in comparison to their larger counterparts.

We believe that the macroeconomic environment is becoming more supportive as central banks are now starting to cut interest rates.

…but also offer strong long-term opportunities

According to research from Siegel and Schwartz in the US, smaller size companies have outperformed larger size when reviewing returns between 1926 and 2021. What is also interesting is that smaller size and larger size companies don’t always perform well at the same time, hence a split between larger and smaller size companies can help improve diversification.

When we focus specifically on sustainable companies, the innovative core products and services they provide already meet a high demand which is expected to grow significantly over the coming years with a growing emphasis on the climate and social equality. In the meantime, companies such as those in the tobacco and oil sectors, are likely to see a drop in the demand.

There are also plenty of examples of companies with poor ESG risk management that have seen a sharp drop in their share prices, significantly denting investors’ confidence, such as Volkswagen or Boohoo.

In summary

We believe a well-diversified portfolio including a mix of company sizes will provide a smoother investment journey for investors, which means having a larger exposure to smaller size companies than market indices.

A focus on sustainable businesses also adds resilience and long-term potential as the world finally focuses on the efficient, cost effective and scalable solutions now available to tackle the many social and environmental challenges we face.