Investors should be patient with underperforming ESG funds

Over the past 12 months UK equity funds with the highest ESG rating have fallen by 13 per cent in the year-to-date, while those equity funds that have the lowest ESG rating have performed the best, dropping only 4 per cent during the same period.

That’s a sharp reversal in the fortunes of ESG funds.

What’s caused that and should we see that recent underperformance as a long-term issue? 

By looking at the factors driving the current underperformance of UK ESG funds and the outperformance of funds with poor ratings, we should get a clearer view as to whether investors can continue to get superior returns from an investment strategy that is more socially and environmentally responsible. 

In the UK ESG funds tend to be overweight in life insurance and consumer discretionary shares.

These are two sectors that score highly on ESG criteria but have also underperformed the wider market since the start of the year.

Listed companies in these sectors typically have a relatively low environmental impact and have detailed policies on hiring from diverse backgrounds and strong records in areas like human rights.

For that reason, ESG fund managers often find shares in these sectors particularly attractive.

Life insurance companies have performed poorly this year, especially as their shares moved in tandem with the underperforming global stock market.

Consumer-facing shares, including Unilever and Sainsbury’s, have also been particularly impacted by rising inflation.

Investors are concerned these kinds of companies will see a drop in consumer spending during the cost of living crisis, hurting their earnings.

While our study looked into large-cap equity funds in the UK, funds with high ESG ratings across all major markets have also underperformed this year.

Most notably, large-cap US equity and global equity ESG funds – which are also overweight US equities – have had a difficult year.

Tech shares

In the US, ESG funds are heavily weighted towards sectors like technology, with stocks like Tesla, Apple and Google ranking very highly in ESG ratings.

Their low carbon footprint combined with their carbon offsetting campaigns means they often rank highly on environmental criteria.

Tech companies also tend to incorporate progressive causes into their social governance structures, which helps their branding as well as their score on social and governance metrics.

However, tech shares have also faced multiple headwinds.

It’s mainly short-term factors that are affecting the performance of ESG funds.

This includes inflation, which has impacted supply chains and hit tech companies’ earnings.

Rising interest rates have also dampened investor sentiment in the tech sector, as it more sharply reduces the present value of earnings that are further in the future – as is the case with many speculative technology companies.

Many of these tech companies have been trading on exceptionally high earnings multiples, making them more vulnerable to any possible economic slowdown.

The more highly rated ESG funds also exclude companies like miners and oil and gas producers, meaning they have missed out on some of the returns on offer as commodity prices surge.

Energy boom

In particular, oil and gas companies have had a strong year, significantly outperforming the wider market.

Russia’s invasion of Ukraine sparked a period of global oil and gas shortages, when energy prices were already rising, directly benefitting the earnings of oil and gas producers.

For example, BP and Shell have reported record quarterly profits in recent months, with both their share prices recording double-digit increases so far this year.

Funds with the lowest ESG rating, which do not exclude oil and gas shares, have been increasing their exposure to fossil fuels as commodity prices surge.

While it is tempting to question the investment case for ESG funds due to their recent poor performance, investors need to be patient.

Over longer time horizons, earnings growth matters.

While a spike in oil and metals prices has occurred over the past year investors will have to work out if they expect that trend in oil and metals prices to continue over the next year.

It’s mainly short-term factors that are affecting the performance of ESG funds.

There is no reason to suggest that investors are going to drop their preference for ethical investing.

Between 2016 and 2021, a period in which oil prices were relatively stable, 57 per cent of ESG indices outperformed their non-ESG equivalents.

This demonstrates that once the energy price boom gets deflated by an increase in supply ESG funds have the potential to outperform non-ESG funds.

UK ESG funds have performed well in the past, as they benefitted from the wall of money investors were looking to allocate to equities with strong ESG credentials.

There is no reason to suggest that investors are going to drop their preference for ethical investing.

Temporary factors may weigh on short-term performance, but investors know that companies that embrace ESG can achieve better profitability than those which don’t, and make for better long-term investments.

Companies that demonstrate good ESG practices have been shown to have better top-line growth than those that don’t embed ESG into their business models. 

These companies should have more supportive employees and customers and are less likely to be subject to regulatory and legal interventions, which can damage shareholder returns.

They should also demonstrate better judgement in allocating capital to promising, sustainable investment opportunities that will help drive the shift to net zero, further enhancing the return on investment for shareholders.

Jonathan Webster-Smith is chief investment officer at Bowmore Asset Management