Investors should be patient with underperforming ESG funds

Jonathan Webster-Smith

Jonathan Webster-Smith

It has been a hard year for UK environmental, social and governance funds as they significantly underperformed the market.

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.

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.