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ESG is having a hard time but look to the long-term

ESG investing is under greater scrutiny than ever, but this doesn't mean its a busted flush
ESG is having a hard time but look to the long-term

There has been a lot of chat about green issues recently, given the scorching UK heatwave with its wildfires and melted airport runways. There is a growing consensus that we must go further and faster to tackle climate change. But for investors, it seems like it doesn’t pay to go green. New research, which won’t be shouted from the rooftops by the ESG PRs, shows that over the last year “the worse a fund’s ESG rating, the better its returns”. But the future of green investing still seems secure – performance has been hit by a unique set of economic circumstances, younger investors are at the forefront of the ESG push, and managers are taking a second look at former no-go energy stocks as decarbonisation plans march forward.

In research which doesn’t make pretty reading for ESG investors, Bowmore Asset Management found that big UK equity funds with the best ESG ratings have performed much worse than funds with the lowest ratings in the past year (see graph below). That’s not a great selling point for the sustainable finance revolution.

The poor performance of ESG funds isn’t surprising, though, given the market backdrop. Oil and gas company share prices have boomed this year, with Russia’s invasion of Ukraine restricting supply and leading to soaring utility prices, while other sectors of the economy have been hit hard by inflation. Given that ESG funds have limited exposure to traditional energy stocks (being unable or unwilling to invest in them) their relatively worse drop in value doesn’t come as a great shock.

Saying that, one thing that ESG fund managers have started to do in this investing environment is to – gasp – put money into previously off-the-table options such as the energy giants. According to recent analysis from Bank of America, around 6 per cent of the 1,200 European ESG funds they looked at now hold Shell. This was nil – nada – at the end of 2021. ESG funds have also increased their exposure to other energy stocks such as Galp Energia and Aker BP. The bank’s analysts said that ESG funds “are revisiting the costs of exclusion”. The argument goes that as companies like Shell invest more and more in a cleaner energy future, they should be viewed as part of the solution rather than as part of the problem.

Whether or not investors agree with that, the immediate ESG outlook doesn’t look too rosy as interest rates could potentially rise much further to see off inflation. Why does that hurt ESG stocks? Well, they tend to be growth-orientated and have benefited hugely from a low interest rate environment and greater amounts of money sloshing around markets due to government stimulus packages and money printing. The direction of travel is clear, with even the European Central Bank getting in on the action and raising rates for the first time since 2011. In this sort of environment, investors tend to move away from riskier assets – hence the big tech sell-off we have seen this year.

But all is not lost. The huge levels of investment in the green transition from major economies such as the European Union support ESG’s long-term prospects. Bowmore’s chief investment officer Jonathan Webster-Smith argues that “over longer time horizons, earnings matter and ESG funds should deliver better returns than funds which don’t consider ESG due to the growth opportunity” and that “the investment that we expect to see within clean energy is going to be significant”.

And the opinions of younger generations should certainly bring a smile to the faces of ESG managers. A recent report from management consultancy Bain & Company found that three-quarters of high-earning millennials think that ESG is “an important factor in investment decisions.” Bain forecast that around half of all assets under management by 2030 will be “ESG-related”, up from around a third today. The centrality of ESG to the future of financial markets looks secure.

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