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Monitor your ESG funds to benefit from market style shifts

ESG funds could have an unintended style bias
Monitor your ESG funds to benefit from market style shifts

Markets have been tanking: as of 13 March the MSCI World index had lost nearly 15 per cent in the year to date in sterling terms. The FTSE All-Share index, which has been exposed to the effects of the Covid-19 lockdown and a gruelling price war in the oil industry, lost nearly 30 per cent over the same period. And very few asset classes have been spared in the sell-off.

Focusing on longer-term trends in the middle of a market sell-off is not easy. Rather than thinking about the bigger picture, many investors are, not surprisingly, concerned about extreme moves in equity markets and how these affect portfolio valuations.

But there are robust strategies for coping and even benefiting when markets appear to be in freefall, as explained in our 'What to do in a sell-off' feature (IC, 6 March 2020). And it is important not to lose sight of investment trends that are likely to hold firm both now and in the future.

Environmental, social and governance (ESG) investing is one such trend. ESG funds have had a better sell-off than some conventional funds so far, in part because the former are insulated from some of the problems in the oil market. To give one example, iShares ESG MSCI USA Leaders ETF (US:SUSL) lost 8.9 per cent between the start of this year and 13 March, a bruising performance that nevertheless compares well with the 10.4 per cent sterling drop in the S&P 500 index.

ESG also remains one of the dominant trends in terms of investor demand, and the events of this year are unlikely to change that. European investors put a net €120m (£104.3m) into sustainable funds alone in 2019, according to research company Morningstar – a record amount that increased these types of funds' assets under management by 56 per cent compared with the previous year.

Even investors who are not interested in investing according to ESG credentials are likely to be affected by this shift. Many fund providers and other professional investors who don’t explicitly specialise in ESG are now applying such criteria to their investment strategies. As such, the funds you hold are increasingly likely to have such a tilt. The sheer volume of money that will potentially go into funds that take ESG approaches in future, combined with changing public opinion on a variety of issues from smoking to climate change, could also have an effect on relevant asset prices.

However, ESG funds can differ significantly, both from the broader market and their peers, in terms of the sectors and companies they will or won’t invest in. This can make a big difference, both to returns and whether a fund fits in with your worldviews, so should be carefully considered. Even if you are not interested in ESG issues, thinking about this could highlight some investment opportunities that others are now missing.



Facebook (US:FB), Amazon (US:AMZN) Apple (US:AAPL), Netflix (US:NFLX) and Google owner Alphabet (US:GOOGL) – the so-called FAANGs – have seen their share prices hit during the recent sell-off, and their high prices have generally made them vulnerable at points of volatility. But they have often led the US equity market in recent years and some of them may prove more resilient during the course of the coronavirus pandemic than others. However, a variety of issues including 'fake news' scandals at Facebook and concerns about working conditions at Amazon mean that many of these stocks do not feature in ESG-oriented funds. And because the FAANGs make up such a large part of the US market, and consequently often feature prominently in conventional US and global equity funds, it can create a dividing line between ESG and conventional funds.

The table below illustrates this. Though far from exhaustive, this selection of funds with ESG, responsible or sustainable processes tends not to include many of the FAANG stocks in their top 10 holdings, and only Alphabet features prominently.


Baillie Gifford Positive Change    
BMO Responsible Global Equity    
Edentree Amity International    
Hermes Global Equity ESG   
Liontrust Sustainable Future Global Growth    
Royal London Sustainable World Trust    

Source: provider factsheets, end of January 2020


Simon Clements, who manages Liontrust Sustainable Future Global Growth Fund (GB0030030067), argues that Alphabet stands out because it shares information via Google, while also doing “a lot of blue sky thinking to solve the problems of tomorrow” and using energy-efficient data centres.

Mr Clements and his team used to hold Facebook in the funds they run but divested of it because they were concerned that the company was not doing a good job of moderating content and was monetising people’s information.

They do not feel that Amazon meets their criteria because of its treatment of employees and because “the destruction of the high street does not benefit society”, while Mr Clements thinks that Apple does not offer solutions to the world’s problems.

But managers differ in their opinions on what they can include or exclude in their funds and there are grey areas. For example, Mr Clements argues that Netflix is “the most likely of the FAANGs to become investable in the future”, on the grounds that it is borderline in terms of sustainability and offers content that is neither beneficial nor detrimental from a societal point of view. But Mike Fox, who works on Royal London Sustainable World Trust (GB00B882H241), suggests that there are greater concerns in the latter area.

“Netflix is on the margins,” he says. “You could say [its] content is a form of art, but it encourages binge-watching. And a lot of its content is quite punchy in nature – they certainly have a serial killer department. With Disney (US:DIS) you get the same [investment] theme – content – but it’s more family-friendly.”

As such, it is always worth understanding the process behind each ESG fund and the investments it may exclude. It is important in terms of whether it meets your ethical views and because you need to know how a fund will deviate from the broader market.


Home market

Another major area where ESG investors can differ from the underlying market is in the UK, where sectors such as oil and gas, mining and tobacco still represent a sizeable chunk of the FTSE 100. This, at least recently, appears to have slightly protected certain funds. For example, Royal London Sustainable Leaders Trust (GB00B7V23Z99), a UK equity fund, was down 15.9 per cent between the start of 2020 and 13 March, compared with a much steeper drop of 28.1 per cent for the FTSE 100 index.

But it is still very important to know what an ESG fund's holdings and investment approach are because they can differ in the extent to which they avoid certain industries. ESG funds may also hold some sectors you might not expect.

Banks, a sector still associated by many with the global financial crash, appear in a number of ESG funds. However some managers, such as Mr Fox, tend to focus on retail banks and steer away from investment banks. Andrew Jones, who works on Janus Henderson UK Responsible Income Fund (GB0005030373), holds Lloyds (LLOY) and Royal Bank of Scotland (RBS), but tries not to invest in banks that lend significantly to companies such as miners which do not meet the fund’s investment criteria.

The UK market has in recent years relied on a handful of big dividend payers, including some in sectors such as oil and gas. So if you invest along ESG lines, when choosing an equity income fund you need to check how it generates income and whether it is too reliant on a few names for payouts.

“We don’t own oil and gas stocks like BP (BP.) or Royal Dutch Shell (RDSB),” says Mr Jones. “They are sizeable sectors but also big income payers. That means that we have to get income from other places.”

For Mr Jones, this means investing in companies such as Severn Trent (SVT) and National Grid (NG.). But the fund can also put up to 20 per cent of its assets in overseas-listed stocks. Mr Jones currently uses around half this allowance, investing in pharmaceutical companies such as Sanofi (Fr:SAN) and Bristol-Myers Squibb (US:BMY), and waste management company Veolia (Fr:VIE).


Style considerations

Whether or not you invest along ESG lines, it can have further implications when it comes to investment style because it often involves excluding some classic 'value' stocks, including parts of the energy sector. In 2016, research by Federated Hermes, an asset manager that takes an ESG approach, found a relationship between 'quality' companies and those with favourable ESG characteristics. The company said at the time: “ESG investors are therefore likely to find that their portfolios have a quality bias.”

Quality-style investing has outperformed value-style investing – investing in shares that you think appear to be trading for less than their value – significantly for more than a decade. But it is important to know that if value stocks rally once more ESG portfolios could be left behind – at least in the shorter term. Circumstances that could prompt a value rally include a surprise surge in inflation – something that could theoretically come about as a result of the hefty fiscal stimulus now going ahead around the world.

Heavy sell-offs in areas such as oil may appear to offer opportunities for investors with a value bias, although when choosing funds or shares in this area carefully assess the long-term prospects for such industries. Funds such as Schroder ISF Global Energy (LU0969110765) have been among those hardest hit in the sell-off this year.

This, and the rise of ESG, may also allow some funds with a deep value approach to find bargains. But with fund managers now looking to prosper from the ESG boom, there may be fewer funds in future that take a dedicated value approach. This means that it is important to read through funds’ investment policies, as well as their managers' commentaries and any communications about possible changes.

Some funds may turn away from ESG criteria to maintain a value approach. Temple Bar Investment Trust's (TMPL) board said in February that it had consulted with shareholders “as to whether they would support the trust declining to invest in companies whose very business model was arguably unethical”. And, based on the feedback received, there was “little support for this measure among shareholders”. The trust is run by well-regarded value manager Alastair Mundy, and its 10 largest holdings at the end of January included BP and Royal Dutch Shell.