- ESG fund performance still holds up over the medium term
- Regulatory changes might bring some clarity for investors but there is a long way to go
Hampered by sluggish performance and the prospect of regulatory changes, it has been a year of transition for environmental, social and governance (ESG) investing. In the year to November 2022, on average, European equity ESG funds underperformed their benchmarks by 5 percentage points, according to Refinitiv Lipper data. That was worse than the 4.6 percentage point underperformance posted by their mainstream counterparts.
Kate Elliot, head of ethical, sustainable and impact research at Rathbone Greenbank Investments, notes that performance headwinds for sustainable portfolios this year included “strong performance from energy and defence stocks… a rotation from growth to value investing, and continued supply chain constraints impacting the flow of materials and labour”. She warns: “Many of these factors are likely to continue into 2023.”
Earlier gains have not been erased entirely, with ESG funds slightly more likely to outperform compared with their conventional equivalents in the three years to November 2022. Climate change and the energy transition have not gone anywhere and many will argue those trends should continue to drive sustainable fund returns over the long term. But this year has shown that it can be hard to argue in favour of ESG based on performance alone.
And as they grapple with weaker returns, asset managers find regulation pulling them in two different directions. On one hand, in Europe they are often accused of greenwashing – that's to say, of talking a good game on sustainability but investing much as they had done in the past. On the other, ESG is now very much a dirty word in some parts of the US, with states such as Texas and Florida pulling assets or banning managers that they believe are discriminating against fossil fuels. Those to have fallen foul of this process include BlackRock, which is hardly considered an ESG darling by climate activists.
Having to strike a balance between conflicting priorities hardly encourages managers to confront one of the elephants in the room - the fact that ESG still means different things to different people.
Research platform Follow the Money has recently found that almost half of Europe’s Article 9 funds – the highest level of sustainability grade for investment strategies domiciled in the European Union, also referred to as ‘dark green’ funds – invest in the aviation or fossil fuel industry.
The common counter-argument is that 'we cannot divest our way to net zero'. Managers would argue that they engage with companies to help them adapt to the energy transition - and that divesting may mean leaving the assets in the hands of an owner who may prove much less concerned about climate change.
“I think stewardship is one of the most important tools we hold,” says Karen Ermel, director of responsible investing at Coutts. But she adds: “We need to be as an industry quite critical on engagement. It can't just be ‘we engage so we can do whatever we want’”.
A further nuance is that some funds use a so-called 'best in class' approach, which selects the companies with the best ESG credentials within each sector, rather than excluding all 'dirty' sectors. These approaches all have their merits, but the question remains of whether investors are clear on the fact that their ESG-labelled fund holds, say, Shell and BP.
Additionally, ESG spans a range of potential issues, from carbon emissions to human rights. These can sometimes be at odds with one other. Different investors will have different values, and views on what ethical or sustainable investing means – and at the moment it is hard for them to figure out whether a given fund is a good fit.
Is change coming?
The Financial Conduct Authority’s (FCA) new proposal on sustainability disclosure requirements and investment labels should go some way towards providing clarity. Funds will be classified according to whether they hold sustainable assets (‘sustainable focus’); aim to improve the sustainability of assets over time, including through stewardship (‘sustainable improvers’); or invest in solutions to environmental or social problems (‘sustainable impact’).
Ermel says that providing better information on ESG criteria to investors is a big focus for the industry and will gradually happen in 2023, albeit on a case by case basis. The FCA labelling rules do not come into force until June 2024 and should be more of a ‘radical shift’.
Morningstar analysts note that the FCA proposal goes beyond EU regulations currently require. The consultation paper says that ‘ESG integration’ funds (which simply consider ESG risks and impacts as part of their investment process) cannot qualify for the labels mentioned above. Yet the proposals also intend to ban funds that do not qualify for any label from using terms such as ‘ESG’ or ‘responsible’. “Most ESG funds will either need to change considerably to meet the sustainable focus or sustainable improvers labels or rebrand themselves,” the research house says.
While ESG regulations are gradually becoming stricter, as usual it all comes down to how rules are ultimately enforced. A number of European asset managers have recently downgraded their funds from Article 9 to Article 8 (‘light green’) after guidance published in July by the European Commission seemingly made it tougher for portfolios to qualify as a ‘dark green’ fund. The issue relates to how much of a portfolio must be held in sustainable investments for it to qualify as sustainable. The EC suggested all issuers of securities in a portfolio must be considered sustainable – but it did not give a clear definition of 'sustainable', and there remains confusion over whether it will enforce a 100 per cent threshold in practice.
As at September 2022, only 6 per cent of Article 8 funds targeted a minimum exposure to sustainable investments above 50 per cent, according to Morningstar. That is partly because some focus on companies involved in the energy transition.
All this points to the fact that while regulations are evolving, they are far from a done deal. There is still a long way to go before it becomes straightforward for investors to understand what exactly it means for a fund to have ‘ESG’ in its name.
