Sustainable funds are down but not out

Global sustainable funds attracted inflows of $13.7bn (£10.9bn) in the third quarter of 2023, just half of the revised $23.6bn in the previous quarter, the latest in a series of quarterly slowdowns for the theme amid spiralling outflows from sustainable funds in the US in particular.

So are investors turning their backs on the sustainable theme due to a change of heart?

We believe something less political is at play. Namely performance issues related to the broader market switch from growth assets that many sustainable funds invest in being in favour, to value assets.

Nick Henderson, fund manager on the team at Columbia Threadneedle Investments, the team behind the growth-oriented CT Responsible Global Equity fund, admits sentiment has “soured”.

But he agrees “that is largely down to underperformance in growth assets in response to the rising interest rate environment, which impairs the valuation of longer duration assets, most notably growth assets”.

The sustainable sector needed to get its house in order, but it is doing so.Will Lough, R&M Global Sustainable Opportunities fund

The higher rate environment also devalues the present value of long-term project work, including the deployment of renewable energy projects, Henderson points out. 

“This comes at a time of geopolitical tensions that has bolstered the traditional hydrocarbon energy market. This inevitably drives investor skittishness,” he adds.

Many sustainable funds cannot hold some of the more value-oriented sectors, particularly in the areas of energy and materials that have been strong performers in the past 18 months, so this has impacted returns and flows.  

David Harrison, manager of the Rathbone Greenbank Global Sustainability fund, says the phenomenal growth in sustainable assets from 2018 until the end of 2021 meant a pullback was inevitable.

He adds: “I would argue this is actually helpful on a longer-term view and does not speak to structural issues”.

Harrison says: “After exponential growth in sustainable assets until the end of 2021, the recent correction will likely be healthy on a longer term view – it has highlighted which businesses have genuinely durable business models and can flourish in any economic environment.” 

Data around slowing inflows for sustainable funds needs to be put in the context of a challenging environment of outflows for equity funds in general during 2022 and 2023. 

The aforementioned data on a slowing in sustainable fund inflows in the third quarter of this year must be put into the context of both global mutual funds and the exchange-traded funds universe suffering actual outflows.

That said, Will Lough, manager of the value-oriented R&M Global Sustainable Opportunities fund, says: “It would certainly be fair to say that high-profile falls in the value of some of the ‘poster children’ of sustainability, such as Orsted in the renewable energy space, have emboldened critical commentators” of sustainable funds.

“In many cases, these precipitous falls have come from a starting point of elevated valuations and expectations,” says Lough, adding that back in 2021 there was a lack of diversification among the fund offerings, meaning investors were over-exposed to the same narrow group of companies, as well as a large-cap and growth style bias. 

By comparison, R&M Global Sustainable Opportunities is a value-orientated stock-picking fund that invests in roughly 50 companies of all sizes – often not found in other sustainable equity funds.

“This is either due to their smaller market cap or because they do not fit the ‘box-ticking’ approach that had, unfortunately, become too commonplace,” adds Lough, “in this sense, the sustainable sector needed to get its house in order, but it is doing so”.

What is the outlook for sustainable funds?

Peter Michaelis, co-manager of the Liontrust Sustainable Future Global Growth fund, brands 2022 and 2023 “very unusual years in investment that have favoured shorter duration assets, except for the AI-related ‘magnificent seven’ in the US”.

He admits this has been a headwind for his fund as “we are looking for those businesses that will grow over the next five years as they deliver solutions to critical environmental or social problems”. 

But Michaelis sees no weakening of these sustainability themes and mega-trends, and we tend to agree. He gives the example of action to reduce carbon emissions. 

“The US Inflation Reduction Act earmarks more than $370bn to fund clean tech, renewables and grid upgrades; the EU has a target of 55 per cent renewables by 2030 and China has ambitious targets to have 1,200GW of renewables by 2030,” he points out, adding that because the cost of solar energy keeps falling, these targets are likely to be surpassed. 

“These companies will continue to see strong growth in the coming years,” Michaelis says.

The global transition to a sustainable economy will see trillions of pounds reallocated and invested into new technologies, services and infrastructure.Ed Heaven, WS Montanaro Better World fund

Ed Heaven, head of sustainable investment on the team behind the WS Montanaro Better World fund, is unequivocal that sustainable investing is “undoubtedly part of the future”. 

“We do not think sustainability is a sinking ship and some of the commentary on its apparent demise have been hyperbolic,” he says. Heaven gives two robust reasons for this stance, other than being a fund manager investing in the sector.

“Firstly, we need to transition to a more sustainable economy to deal with major problems such as climate change. There is no question about this, just look at the science,” he says.

Secondly, the long-term growth opportunities offer probably the most exciting growth story of our lifetimes, according to the fund manager.

“The global transition to a sustainable economy will see trillions of pounds reallocated and invested into new technologies, services and infrastructure,” says Heaven.

And what about the rotation from growth to value? “Just look at the reaction of growth stocks to recent favourable inflation data out of the US and UK,” Heaven says, “we have seen the share prices of many of our sustainably-focused businesses bounce”. 

As inflation looks to be on a downward trend, leading to predictions of a peak in interest rates, that bounce could be a longer-term one for the overwhelmingly growth-focused sustainable sector.

Darius McDermott is managing director of Chelsea Financial Services and FundCalibre