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BLOG: ESG funds can be as risky as traditional stocks

The ESG sector is a global phenomenon and has held up well in the face of widespread investor fear. But ESG funds are not inherently less risky than common stocks, but come from a very low base.

The UK ESG boom really took off at the end of 2019 as the trickle of investor interest that started in 2018 turned into a flood. As fund management business teams spotted the emerging trend, new funds were launched and marketing spend focused on a nascent industry, broadening awareness and increasing demand ever further.

The funds have seen average monthly inflows of £63m in 2019 rise to £930m in 2021, making it by far the most successful investment trend of recent years.

The numbers are huge – between the start of 2019 and August 2022, ESG equity funds raised a net £20.5bn of capital from investors, compared to a net outflow of £850m from investors. all other types of equity funds, mainly due to strong sales. in disadvantaged categories such as UK and European equities and, at least until recently, income funds.

We’ve seen similar patterns unfold across our global network, but with slightly different phasing. ESG is certainly a global phenomenon.

ESG is not immune to market turbulence in 2022

The 2022 bear market reflects the necessary re-emergence of risk as a differentiator in markets after years of sedated central bank money printing. Inflation, war, supply chain disruptions and the energy crisis are all part of the picture.

This has been particularly painful for non-ESG funds in the UK; they suffered strong outflows of £7.9bn between January and August. The ESG was not immune to the turmoil. Although ESG funds continued to attract new capital (£3.6bn), the inflow rate slowed markedly, falling to just £95m in August, the worst month in three years.

ESG funds are not inherently less risky than equity funds, with a similar sector composition, so their relative success in raising capital in 2022 cannot be explained in this way. The companies and sectors they avoid certainly produce more negative economic externalities, but these costs are often socialized rather than borne by the companies themselves – climate change or worker exploitation are two examples.

The growth profile or revenue generation of companies with good ESG credentials is likely to be quite similar to other types of companies, once industry differences are taken into account. On the contrary, the relatively large weighting of technology companies that more easily meet ESG criteria pushes at the top portfolio risk.

The key point is that ESG comes from a very low base – assets under management remain a tiny fraction (less than 4%) of all equity funds – and is in a clear structural growth phase . This means that there is both a strong tendency for investors to buy and a relatively small pool of assets that could suffer from selling activity. This explains why fund flows have held up so well this year in the face of widespread investor fear.

ESG tensions are rising to the surface

However, some tensions are surfacing that could slow the medium-term progress of the ESG fund industry.

First, performance. Analysis by Bloomberg shows that global ESG funds (the largest category) have lagged the broader market by 2.6 percentage points per year over the past five years, returning 6.3% on average. A relative underweight to energy stocks which are currently behaving like bandits is surely hurting returns this year.

This didn’t deter early investors, but it will become increasingly important as the category becomes mainstream.

Longer term, from a capital pricing perspective, if assets that are not ESG discounted consistently trade at a steep discount, they are likely to offer superior returns to their investors. , unless regulation or taxation increases the costs for these companies and thus reduces their value. These forces of financial gravity would inevitably end up slowing the flow of capital to ESG.

The second problem concerns the selection criteria. A company deemed acceptable by one fund manager may be out of the question for another, so how does a fund investor know what he is buying? Likewise, how do you deal with companies in transition? For example, when does a former oil producer building his renewable energy business get credit for that business? This thorny question currently exercises many fund managers. Additionally, blurred lines and accusations of greenwashing have caused a backlash against ESG over the past year.

The public views ESG as a ‘moral exercise’

Finally, there is a structural flaw, identified by Stuart Kirk, former head of sustainable investing at HSBC. It is related to the second point above. He highlights the fact that ESG has two meanings – the first is that to understand a company’s risk-adjusted returns, environmental, social and governance issues need to be considered.

This is essential for fund managers evaluating investments and will determine a fund’s ESG score, but it is not what the public understands by this term. It allows any company to be in the portfolio as long as the risks associated with its pollution or poor governance affect its price.

In contrast, the public sees ESG as a moral exercise in using the power of capital to “do the right thing” and effect positive change. Kirk argues that this disconnect will hamper the development of the industry. This is probably also the origin of the greenwashing issue, if you think about it.

I don’t think these problems are fatal. The fund management industry is extremely creative, adaptable and responsive to investor needs.

A proliferation of sub-themes and impact investments such as “renewable energy” (currently selling like hotcakes on the Calastone network), for example, are helping to sharpen investor expectations of of a fund and the manager’s investment process. And if the issues aren’t resolved, regulators will roll up their sleeves and get involved, especially as the category grows.

For me, it is above all a question of communication. Clarity of the fund’s mandate and investment process should help investors make the right choice.

I am bullish on ESG. It continues to attract capital in the worst economy since the global financial crisis, suggesting it may also grow in the long term.

The ESG has stolen the show for the past three years and still has plenty of encores to come.

Edward Glyn is Head of Global Markets at Calastone