- Active ESG funds have performed worse than their conventional counterparts on average
- Tech stocks' predominance has shaped the market in 2023, and not all green funds invest in them
- New FCA labels should help investors know what to expect from ESG
Funds investing with an environmental, social and governance (ESG) tilt have followed up a poor 2022 with a lukewarm 2023, as mixed performance and weak flows weighed on the sector. A range of market, political and societal factors are to blame, but investors can take some solace from the fact that the underlying trends that first prompted the move towards sustainable and ethical investing have not gone away.
A new set of regulations from the Financial Conduct Authority (FCA) should make it easier for investors to avoid 'greenwashing' and pick green funds that reflect their views on sustainability next year. In the meantime, investors will hope that the recent market rally is a sign of things to come.
Jason Hollands, managing director at Bestinvest, sums up current trends by stating: “Interest in ESG funds seems to have lost momentum over the last couple of years." Inflows data partially backs this up, particularly for 2023. In the first 10 months of the year, responsible investment funds saw outflows of £1.7bn, with September registering the highest outflow on record, according to the Investment Association.
The sense is that the poor performance of ESG funds last year has translated into investor outflows this year, particularly as returns remained underwhelming.
Hollands points to the 2022 performance of commodities, oil and gas, and defence stocks, which performed well in the aftermath of Russia’s invasion of Ukraine and which are necessarily excluded from most sustainable funds, as one factor in the underperformance. Meanwhile, valuations for the growth stocks in which ESG funds tend to invest have come under pressure from higher inflation and interest rates. This year, that has been compounded by operational problems for major renewable energy companies such as Ørsted (DK:ORSTED).
Dzmitry Lipski, head of fund research at Interactive Investor, agrees, noting that a combination of higher interest rates, inflation and energy prices have both impacted performance and shifted sustainability and ESG from the investment agenda, “at least in the near term”.
On average, ESG funds are doing worse than their conventional counterparts, according to Refinitiv Lipper data. The chart below shows the extent to which ESG and conventional active equity funds have underperformed their respective benchmarks on average over one, three and five years; conventional funds come out on top across all timeframes. This year, 60.4 per cent of conventional funds underperformed, compared with 69.2 per cent of ESG funds.
It was generally a difficult year for active fund managers of all kinds to beat their benchmarks, given a large portion of the market rally was driven by the so-called Magnificent Seven tech stocks whose sheer size makes them hard to overweight. Similarly, Jake Moeller, associate director of responsible investment at Square Mile, argues that generic ESG funds and trackers are more likely to have higher exposure to these stocks compared with actively managed sustainable or impact funds – and as such have tended to perform better.
For example, the Vanguard ESG Developed World All Cap Equity Index Fund (IE00B76VTN11) was up 19 per cent in the year to 18 December. The fund lists all the seven tech giants among its top 10 stocks; the index it tracks mirrors the FTSE Developed All Cap index, a non-ESG benchmark, comparatively closely, although it does apply a range of exclusions.
By comparison, popular active funds such as Baillie Gifford Positive Change (GB00BYVGKV59) and FP WHEB Sustainability (GB00B8HPRW47) were only up by 5.9 per cent and 1.6 per cent, respectively – the second has none of the Magnificent Seven among its top 10 holdings, while the first only lists Tesla. Some impact and thematic funds fared even worse than that; Ninety One Global Environment (GB00BKT89K74), which has a narrower focus on decarbonisation, was down by 3.5 per cent; Guinness Sustainable Energy (IE00BFYV9L73), which invests in companies involved in the generation, storage, efficiency and consumption of sustainable energy sources was down 8.8 per cent. Notably, this fund was the fourth most purchased on the Bestinvest platform in 2023 despite its struggles. The year-end rally seen since the end of October, which has been of particular help to growth-sensitive shares held by sustainable funds, will have given holders renewed cause for optimism.
On the investment trust front, we have written extensively about how 2023 has been a complicated year for renewable energy trusts, including popular choices such as Greencoat UK Wind (UKW) and The Renewables Infrastructure Group (TRIG), as the portfolios grappled with rising discount rates and their underlying holdings faced up to rising costs. The former has risen by 2.9 per cent on a one-year basis, while the second has fallen 11 per cent. Impax Environmental Markets (IEM), which invests in small and mid-caps across sectors such as waste management, energy efficiency and water infrastructure, has dropped 4.5 per cent.
New definitions
Performance aside, working out which fund best suits your preferences can still be a challenge. In November, the Financial Conduct Authority (FCA) introduced labels to help investors distinguish between the different types of ESG funds, as well as an anti-greenwashing rule. The new labels are:
The fourth category was a new addition to the labelling system, added after last year’s FCA consultation following feedback from the fund management industry.
The labels were broadly welcomed by experts and Moeller says they should be helpful to end investors. He notes that they still allow management firms to be “aspirational”, but in a way that “will make it clearer to end investors what it is that they are trying to achieve for them”, removing some of the “subjectivity” that has at times paved the way for funds pretending to be something they are not.
The new rules will become effective over the course of 2024, but it might take some time before the industry fully adjusts. The short-term horizon is similarly uncertain when it comes to performance.
“I think the outlook for these types of strategies in 2024 is unclear,” says Hollands. He points to energy prices and political uncertainty as two of the big factors at play. “Output is being limited by Opec+ to support prices, which should support profits at the oil majors,” he says – which would presumably hinder the [relative] performance of sustainable funds. Meanwhile, a Trump victory in the US presidential election next November “could see a significant retreat from green policies in the US”, he adds.
But Moeller stresses the long-term nature of some of these investments. “Some sustainable investments require a longer time horizon than those that aren't,” he says. “If you think that tech stocks are going to keep rallying, some of those stocks are not going to be in sustainable funds, so you might be disappointed.”
Checking the underlying holdings of the funds in your portfolio remains key. Some ESG and sustainable funds can be quite racy, which remains tricky at a time of high interest rates, even with the hope that base rate cuts might emerge next year. Lipski also notes that there is a lack of green options in sectors such as equity income, so creating a balanced portfolio with a sustainable tilt can be hard.
But the long-term need to decarbonise remains, and patient investors should ultimately be able to benefit from it. “Global sustainability trends remain unchanged, and in some instances, even accelerated, such as the energy transition from fossil fuels and increased demand for renewable energy,” says Lipski.
