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ESG funds: darker clouds ahead?

ESG funds are performing less well this year but long-term prospects look good
April 15, 2021
  • ESG funds may not enjoy the spoils of 2020’s performance in 2021
  • But long-term fundamentals are good for sustainable investors

Asset managers are often quick to relay how investing according to environmental, social and governance (ESG) principles can boost investment performance. The theory makes sense. Sustainability analysis should, when approached thoughtfully alongside more traditional analysis, improve insights and potentially enhance performance.

But funds that take an exclusionary approach to ESG automatically narrow their investment universe and the prospects for the year ahead may not be as rosy as they were last year. In the absence of unilateral standards, funds managers all have their own take on ESG investing. But if a fund is classed as ‘sustainable’ there are a number of assets it is unlikely to include: oil companies, arms manufacturers and tobacco companies, for example. 

Morningstar’s sustainable funds universe shows a modest – but significant – outperformance, both last year and over longer time horizons. 

Its sustainable fund group includes around 800 open-ended funds and exchange traded funds (ETFs) domiciled in Europe that, by prospectus, factsheet, or other available resources, have a sustainability objective and/or use binding ESG criteria for their investment selection. It does not include funds that  ‘formally integrate ESG considerations’ in a non-determinative way, for example, as nearly all funds do now.

Morningstar’s global large-cap equity growth sustainable fund group increased last year by 28.8 per cent. That compares with a 27.9 per cent average rise for its traditional counterparts. Large-cap European equity sustainable funds averaged a 1.1 per cent rise while their traditional counterparts fell, on average, by 1.8 per cent. Global emerging markets and US large cap sustainable funds outperformed their traditional counterparts by two percentage points on average. 

These results are unlikely to come as a surprise, as traditional energy companies – avoided by sustainable funds – had a very difficult year. Royal Dutch Shell (RDSB) and BP (BP.), for example, were down 42 per cent and 45 per cent, respectively. Technology companies, and those involved in electric vehicles and renewable energy, had a very strong year, and tend to be popular among sustainable managers.  

The chart below shows the recent huge divergence between equities in the energy sector. MSCI Global Alternative Energy Index includes global companies of all sizes that derive at least half of their revenues from products and services in alternative energy. Vestas (DK:VWS), Ørsted (DK:ORSTEDand Enphase Energy (US:ENPH) make up 38 per cent of the index, which has 69 constituents in total. At the end of March, the index had a forward price/earnings (PE) ratio of 30 times. 

MSCI World Energy Index, made up of 52 companies primarily in oil and gas, trades on a forward PE ratio of 16.6 times, with Exxon Mobil (US:XOM), Chevron (US:CVX) and Total (FR: FP) making up 32 per cent of the index at the end of March. While the alternative energy index has performed far better over the past 12 months, since the start of 2021 the traditional energy index has increased 16 per cent while the alternative energy index has fallen 11 per cent. 

The rotation back towards ‘value’ stocks may continue to play out, as as Investors Chronicle columnist Bearbull suggested last week. “If these trends continue to reverse over the year ahead, the share prices of some sustainable companies could suffer, which will impact the performance of sustainable funds,” says Dominic Rowles, investment analyst at Hargreaves Lansdown.

 

ESG still supported by tailwinds 

For long-term investors, sustainable investing still looks like an attractive strategy. As Rowles points out: “We’re likely to face a growing need for more sustainable goods and services, and companies that are more sustainable than their competitors have the potential to perform well.”

Jack Turner, investment manager at 7IM, still has a positive outlook on ESG ETFs that screen on ESG factors, but attempt to get broad market access. While ESG ETFs generally underperformed broader indices in the last quarter, as oil prices recovered, active managers in general performed worse, according to Turner. 

“The increase in yields has been significant, but looking ahead I think the talk of a rotation is overdone,” he says. “Monetary policy will remain very accommodative and with Biden in office there is nothing to stop the move towards sustainable investing.”

Turner points out that asset managers are increasingly using ESG ETFs to improve the overall ‘ESG rating’ of their portfolios, and says: “I can’t see that changing any time soon”. However, more esoteric thematic ETFs may struggle. As we pointed out in The drawback of thematic ETFs, some niche climate-related ETFs have boomed since the sell-off last year, with a large proportion of retail investors, and may well be in bubble territory.   

Ben Seager-Scott, head of multi-asset portfolios at Tilney, says: “I think good ESG managers should be able to thrive through the business cycle by investing in companies that are good for investors as well as for the planet.”

He adds that while the short-term is very difficult to call, “on a medium-term basis much-needed developments around regulations and infrastructure spending as many economies look to ‘build back better’ mean that there continue to be good reasons to consider ESG investing”.

Regardless of how ESG funds perform over the next year, the prospects of slightly worse short-term performance should not put you off aligning your investment objectives with your personal values. There will be times when market conditions are beneficial and times when they are a drag, but timing these is extremely difficult.

 

Fund picks

Rowles suggests BNY Mellon Sustainable Real Return (GB00BD6DRD55) as a conservative option which could help reduce risk in a wider portfolio. The fund aims for a real rate of return equivalent to cash plus 4 per cent a year, over five years, before fees. 

The fund has 174 holdings with 53 per cent in equities, 15.5 per cent in alternatives, 6 per cent in corporate bonds, 5 per cent in emerging markets debt, and the rest mainly in stabilising assets and hedging positions.      

Stewart Investors Worldwide Sustainability (GB00B7W30613), managed by Nick Edgerton and David Gait, is a relatively concentrated but well diversified equity fund with 51 holdings. It had 25 per cent invested in Europe and the Middle East, 25 per cent in North America, 12 per cent in Japan, and 10 per cent in emerging markets, at the end of February. 

The fund has a large exposure to healthcare at 25 per cent (versus 11 per cent for MSCI AC World Net Index) and information technology at 32 per cent. While these are growth sectors, the fund has a history of performing well in weaker markets and slightly underperforming in strong markets, which could make it an attractive prospect in the current market environment. 

It’s largest three holdings at the end of February were California-based cyber security company Fortinet (US:FTNT), Italian multinational biotechnology company DiaSorin (ITA:DIA) and German Semiconductor manufacturer Infineon Technologies (GER:IFXX.N).

While sustainability is less advanced in Asia than in the west, there is great growth potential in this part of the world. Stewart Investors Asia Pacific Leaders (GB0033874768) has slightly underperformed recently, partly because of a small position in China - 5 per cent of its assets. But it has a strong long-term record of performance and identifying companies with strong ESG credentials. 

iShares MSCI World ESG Screened UCITS ETF (SAWD) is a good passive way to get core global equity exposure with an ESG tilt. The fund screens out exposure to controversial weapons, civilian firearms, tobacco, coal, oil sands, and UN Global Compact violators.

The fund's ongoing charge of 0.2 per cent is the same as its non-ESG counterpart and it provides a similar risk profile. Like the conventional global index, Apple (US:AAPL), Microsoft (US:MSFT) and Amazon (US:AMZN) are its largest three constituents, making up 10.3 per cent of the fund as of 8 April.  

 

Fund performance

Fund/benchmark (%)1 year total return (%)3 year total return (%)5 year total return (%)10 year total return (%)
BNY Mellon Sustainable Real Return20.55   
iShares MSCI World ESG Screened UCITS ETF 36.81   
Stewart Investors Asia Pacific Leaders Sustainability39.1943.1480.70160.51
Stewart Investors Worldwide Sustainability32.4047.0492.42 
LIBOR GBP 1m +4% 4.0614.0724.2555.36
MSCI AC Asia ex Japan index40.7635.60104.51125.49
MSCI ACWI index36.0449.4398.69190.10
Source: FE Analytics, 09.04.21