Investors who have made environmental, social and corporate governance (ESG) considerations a mainstay of their portfolios could be blindsided as stocks shunned by such strategies start to outperform.
ESG investing’s continued rise has been bolstered in recent years by performance figures that show the strategies are able to outperform the wider market – seen as proof that investors need not sacrifice returns when focusing on issues such as sustainability.
Part of this outperformance is down to these funds’ bias towards ‘quality’ stocks, a section of the market that has flourished since the financial crisis as nervous investors sought out reliable companies.
But recently these shares have begun to underperform.
Rob Morgan, a pensions and investments analyst at Charles Stanley, noted: “Energy, mining and mainstream banks have long been excluded from most [ESG] funds, and that is likely to have detracted from performance this year.
“If a fund has strict criteria in this regard, you have to accept these stylistic imbalances and that the manager is not necessarily able to fully replicate exposure by proxy.”
This shift towards stocks commonly seen as value plays could prove painful for investors. UK assets under management in ESG strategies have risen from £1.3bn to £3.7bn since 2009, with retail investors accounting for more than a third, according to Eurosif, a Brussels-based organisation focusing on responsible, sustainable and ESG investing.
Lewis Grant, a global equities manager for ESG-focused fund house Hermes, acknowledged a statistically significant relationship existed between “high-quality” company traits, such as strong balance sheets and cashflows, and favourable ESG characteristics.
Hermes’ research showed that while these stocks outperformed their peers by 30 basis points a month on average, there were times when they struggled.
“The periods in which poorly governed companies have outperformed have tended to correspond to those periods in which cheap firms have also outperformed – the junk rallies of October 2015 and March 2016, for example,” Mr Grant explained.
But given the strong growth and popularity of the ESG style, commentators have urged the need for a long-term view.
Gill Hutchison, head of investment research at the Adviser Centre, said: “For the really dedicated ESG investors, they need to be driven by the long term and, given their restricted universe, have to be prepared to ride out market rotations.
“Although difficult to evidence, it feels intuitive that good ESG companies stand a better chance of building successful, sustainable businesses that stand the test of time.”
Mr Morgan said that such imbalances could even out over long periods – but he warned patience would be required.
