Active management matches clients to the right ESG funds

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Royal London Asset Management
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Supported by
Royal London Asset Management
Active management matches clients to the right ESG funds
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Throughout the crisis, companies that have strong sustainable credentials have tended to outperform those that do not.

ESG portfolios have fared better than conventional portfolios and are attracting record levels of cash as they have proved they can offer comparable returns.

Figures from Morningstar show that sustainable funds recorded inflows of $71.1bn (£53.6bn) in the second quarter, sharply contrasting with the general equity outflows seen over the past year.

The growing popularity of ESG has sparked fears of a post-Covid bubble, reminiscent of the technology boom in the 1990s

With the pandemic putting the focus on sustainable issues, it could lead to increased adoption of socially responsible investing and prove to be a major turning point for ESG.

However, the growing popularity of ESG has sparked fears of a post-Covid bubble, reminiscent of the technology boom in the 1990s.

Emma Foden-Pattinson, investment manager at Charles Stanley, says: “ESG bubbles could be formed as a result of investors seeking to invest in companies with high ESG ratings without taking into account other fundamental areas, such as valuations.

“As a result it can lead to some companies trading at very high valuations which might not be justified.”

Is there a risk of a bubble developing?

One of the key reasons that sustainable investing has seen a boom in recent months is because the crisis has shone a spotlight on the role good businesses play in society.

However, some experts say the outperformance is due to the fall in oil prices and a shift from riskier assets to more defensive sectors.

Record inflows into ESG funds are helping to drive up the value of companies with green credentials.

With the rush to invest more in a narrow set of assets, ESG funds could end up being overvalued.

While many experts agree that ESG stocks have pushed above what they are actually worth, it appears we are still some way off a bubble.

David MacDonald, founder of financial advisory business The Path, says: “Of course, some stocks have seen meteoric rises and the shares with superior ESG scores certainly trade at a premium, but as it stands this difference is only marginal.

“A good financial adviser, with a robust research process, can usually separate out the green from the greenwash – and ultimately determine whether it is a premium worth paying. So, I do not believe we are in bubble territory just yet.”

Chris Tanner, co-lead investment adviser to JLEN and partner at Foresight Group, points out: “Environmental criteria are increasingly written into regulation and must be complied. Therefore investing into funds with strong, genuine ESG credentials probably won’t result in a bubble. 

“However, if ESG funds are defined by a narrow ‘tick box’ criteria that allows for companies to greenwash their credentials, this may lead the market to downgrade the value of those with no real underlying ESG pedigree.”

Cutting through the hype

One of the biggest challenges facing advisers is finding a fund that is genuine and meets the need of the client.

Plenty of companies in recent years have jumped on the ESG bandwagon in the hope that aligning themselves to the green cause will increase profits.

The vagueness of current ESG ratings can provide an obstacle when comparing performance between companies, amplifying the risk of greenwashing.

Critics also argue that corporate ESG disclosure is often lacking and that the data is poor.

Mike Myers, investment manager and head of socially responsible investing at Punter Southall Wealth, says it is important to go with fund managers who generate ideas rather than use an ESG ratings agency.

“Heavy reliance or filtering by ESG ratings attributed from an agency is not an acceptable practice in our view,” he notes.

Mr Myers says thematic managers who generate ideas by evaluating global megatrends and identifying long-term structural growth themes have a greater advantage identifying opportunities.

He adds: “Another significant aspect is the fund manager’s ability to interpret and digest the non-financial factors relating to the underlying investment and how they make their own assessment on the ESG credentials of the potential investment.

“Allocating to managers with different but complementary approaches will aid diversification, mitigate concentration risk and ultimately achieve a better outcome for the client.”

With all the hype surrounding ESG, there is growing concern that some funds have been overbought.

Bruce Jenkyn-Jones, co-manager of the Impax Environmental Markets investment trust, says investing with an active fund manager is the key to being able to avoid stocks that are mispriced.

He says: “Active managers seek to get underneath the skin of a company to work out what is really going on behind the scenes. It is also important to look at the ESG activities of these companies in detail and ask yourself how they are integrating ESG risk considerations into their practices.”

Opportunities

The performance of sustainable funds during the pandemic means the integration of ESG factors into portfolios is likely to become the new normal.

With the pandemic fuelling greater interest in ESG from clients it provides an opportunity for advisers to grow their businesses.

According to a recent Schroders UK adviser survey, 65 per cent of advisers said the crisis will increase the attention they pay to the ESG risks associated with investments.

Meanwhile, 88 per cent said the coronavirus crisis reinforced the importance of stewardship and using an asset manager who actively engages with company management.

Mr Jenkyn-Jones says environmental markets as a whole offer long-term opportunities, particularly in companies involved in clean energy, water treatment, waste technology and sustainable food. 

He says: “Given the origins of Covid-19, there has been a distinct focus on the sustainable aspects of the food supply chain recently, which is driving opportunities in stocks in this area.

“In addition, climate change continues to threaten the global economy and this has led to an increased focus on renewable energy infrastructure.”

Mr Tanner suggests that renewable infrastructure funds are a good proposition because the government’s target of net zero emissions by 2050 is driving investment in this space.

He adds: “Though renewable energy is now a mature and well-understood asset class in its own right, the growth potential is still very large.”

Gemma Woodward, director of responsible investment at Quilter Cheviot, says the business prefers to focus on how asset managers incorporate ESG into their investment process.

She says: “Part of our fund research team’s remit is to understand how the different managers we invest with approach stewardship and ESG integration. While at a house level there may be a process in place, we need to understand how that works both on a team and fund basis.

“When it comes to identifying investment opportunities for our sustainable or positive change strategies, the focus is driven by either the sustainable thematic approach or by due diligence in understanding how funds might fit within the positive change approach.”

Stephen Little is a freelance journalist