Also known as ‘responsible investing’ is a trend that has swept vigorously through Wall Street and the retail investing community. Centred around Environmental, Social and Corporate Governance ideals, investment banks and fund providers have clamoured to construct new funds and ready-made portfolios for investors exclusively built with the most ESG-friendly companies in mind.
Why has this become so trendy, and is it actually worth jumping on the bandwagon? Does ESG investing deliver better returns for investors, or is it worse for your portfolio?
This article will aim to answer all of these questions and make the case of why ESG investing might not be all it is cracked up to be, and what you need to know as an investor before putting your money to work in a fund with an ESG mandate or single stock names.
How can you invest in ESG?
There are 2 options. Firstly, you could invest in clean energy stocks, or those that play on the environmentally friendly theme, such as solar energy companies, hydrogen fuel cell providers or the most popular, EV manufacturers. These companies really led the momentum trade back in late 2020 and early 2021, but not so much now.
2022 provides a stark contrast, in a world where there is a global energy crisis and soaring commodity prices, oil majors and the like are back in favour, despite shunned when it comes to investing in ESG.
In fact, energy has outperformed every other sector as well as the broader benchmark markedly in 2022…
Solar and hydrogen energy sources are simply not developed enough or commercially viable yet to overcome this challenge.
With large swathes of Europe relying on Russia for gas supplies, the world is re-thinking its energy dependency and it will ultimately come at the expense of ESG mandates and environmental sensitivity in the immediate, as governments prioritise maintaining stability to both energy sources and commodity prices.
The rising civil unrest in third world countries has exacerbated this as prices have started to spiral out of control. Those with the lowest disposable income will be affected the most by inflationary pressures.
It’s hard to convince people to buy an electric vehicle or install solar panels on their roofs when they are struggling to make ends meet. Meanwhile, oil stocks are hitting all time highs as they post record earnings.
The second option is to invest in an ESG-themed fund, also known as a ‘responsible fund’. These are typically funds constructed by institutional investors with specific mandates, such as screening out companies that are deemed environmentally unfriendly or provide negative externalities to the wider community by producing their products or services.
Examples of these include tobacco, alcohol and gambling companies that provide ‘demerit goods’, as well as defense companies specialising in the manufacturing of arms and weaponry.
ESG fund flows have seen a massive wave of popularity, as many investors feel a duty to put their money towards what is deemed a good cause, but have these funds outperformed?
ESG Performance
Well, many were successful in 2020, but since then ESG-themed investments have become one of the most crowded trades, according to Bank of America.
This has led to many ESG-related stocks becoming severely overvalued, many of which are ‘revenue growth stories’, meaning they do not make a profit today but promise high growth and high returns in the future.
With a negative backdrop of rising interest rates, these stocks went through a massive re-rating, some crashing over 75% from their all-time-highs. Stocks with no current free cash flow are highly sensitive to rising interest rates, and these fell out of favour and severely underperformed the benchmark indexes such as the S&P500.
Not only did ESG funds massively underperform the index in the past 15 months, but they also charge substantially higher fees than a passive index fund.
As a popular theme trending throughout the investment community, institutional investors jumped on the opportunity to try to sell a product. At the end of the day, fund managers look to bring in as much capital as possible.
The success of the firm is directly correlated to the assets under management the firm has. The more assets they manage, the more they bring in as management fees.
How are companies screened for ESG?
In 2021, many funds were forced by regulators to stop referring to their funds as ESG funds as they did not in fact meet certain criteria to qualify as such. The process of misleading investors to bring in capital for ESG funds was labelled ‘Greenwashing’.
Not to mention that this ‘one size fits all’ approach for screening companies out due to arbitrary scoring has led to the exclusion of some of the best performing stocks in the market.
In an effort to simplify things, large numbers of ‘ESG’ scores and metrics now rank investments on all manner of different variables to determine which companies can or cannot be included within new ESG investment products. Said another way, which companies are good, and which are bad.
Wall Street favours these scores because they’re (apparently) easy to produce, can be neatly ranked, and they can charge for them. Now, you might argue that the worst is behind them for ESG investors, but that does not seem to be the case.
The outperformance of energy in 2022 relative to the S&P looks set to continue. With the invasion of Ukraine by Russia, commodity prices look set to remain elevated. In addition to this, Savita Subramanian from Bank of America highlights that energy is still severely underweight in investor portfolios, largely due to its exclusion in ESG funds.
As inflationary pressures continue, investors will look to hedge their portfolio in stocks that do well when oil remains high. The Ukraine invasion has also led to defence stocks soaring on increased government spending, with names like BAE Systems up over 30% year-to-date.
So, in conclusion, it’s hard to say that ESG investing is really worth it. It may bring investors satisfaction knowing they are allocating capital to companies trying to better the world, but it’s a stretch to say that ESG investing has the potential to deliver outsized returns.
Always look at the full costs of investing in actively managed funds and see how they perform relative to bench markets after factoring in any fund investment fees.
