Some ESG funds have had a tough time recently, but understanding the results depends on how you define an “ESG fund.”
This downturn has been most pronounced for “ESG funds” defined as the (typically passive) large cap U.S. or global equities funds that are labeled ESG because their top holdings screen well in a superficial way on common third-party ESG ratings. These funds typically hold companies that have the resources to provide robust disclosures and are fairly carbon light by Scope 1 and 2 measures. They also have relatively fewer human capital resources, pay higher wages and suffer from fewer issues pertaining to factors such as workplace safety. It is these funds that have seen a disproportionate sell-off because they are longer duration, growth-biased and their valuations have previously benefited from rock bottom low discount rates. Therefore higher inflation and lower liquidity are headwinds to which they are very vulnerable. On the other hand, value-oriented equities, including resources, as well as companies benefiting from the buildup in the capex cycle and the easing of supply chain bottlenecks, have outperformed. In other words, performance has had less to do with ESG and more to do with the asset classes a fund is invested in.
ESG-integrated funds, in which ESG considerations are thoroughly taken into account in the context of the risks and opportunities of the investments, can and do span the spectrum of style biases, including value, and do include funds that may outperform in the current environment.
Structural Tailwinds for Sustainable Funds
When it comes to sustainable funds, especially those with a lower carbon focus, the accelerating trends toward climate change mitigation and global efforts to cut carbon intensity are now structural, and will not be much impacted by market rotation. Eighty percent of governments have made decarbonization commitments (versus less than 10% five years ago) and legislated green infrastructure spending. Additionally, more companies are announcing voluntary net zero or other climate pledges, regulatory pressures are intensifying and consumer awareness is escalating. These developments suggest a dominant investment theme for the coming decades, with capital moving at an unprecedented rate to fund innovations and renewable technologies that can displace high-carbon activities and aid ESG transition. Falling prices of this technology and financing that will remain cheap relative to history will further drive a shift to lower carbon solutions. So while funds with this thematic focus may also see some adjustment due to Federal Reserve tightening and general market repricing, we expect them to recover their poise, anchored to the tailwind of the longer term trend.
Investors Increasingly Impact Oriented
Finally, impact-oriented funds, which are predicated on a values alignment with clients on the basis of any number of social or environmental objectives that they would like their money to fund, will of course also be impacted by the current phases of the policy, liquidity and market cycles, but should generally be considered as long-term investments focused on funding positive change for people and/or planet alongside garnering financial returns. We further note that targeted impact focused on identifying investment opportunities and themes, such as natural capital, health and inclusion, is becoming more relevant for public equity and fixed income investors. In the past, impact investing was primarily handled through private equity; in recent years there has been a growth of public companies with capabilities that solve for societal needs, such as the energy transition and agricultural technology advancements. As sustainable and impact investors turn to relevant programs, such as the United Nations Sustainable Development Goals, to target societal needs, alignment to such initiatives should continue to gain momentum, supporting the growth of impact strategies.
Investor Commitment to ESG Is Growing
To the extent that some investors may have been mis-sold passive ESG-labeled strategies in recent years as a panacea or magic pill to achieve persistent outperformance over every time period, there may indeed be a need for a more nuanced assessment and understanding of how ESG integration can enhance long-term returns by channeling capital into more durable businesses and protecting client assets from financial and non-financial risks that companies may face as a result of changing social and environmental trends. The more investors understand such trends the more likely they are to see the value of ESG integration.
In addition, investors’ commitment to ESG is increasingly grounded in aligning and expressing their values and purpose via their investments. Schroders’ annual Global Investor Study, which surveys over 23,000 investors worldwide, found in 2021 that 60% of U.S. investors believe investment managers and major shareholders should be responsible for mitigating climate change. This number climbed even higher among millennials (70%). Investors, especially those in younger generations, are seeing sustainable investments as a way to contribute to change that they want to see, whether it is decarbonization, protection of natural resources, better treatment of workers, diversity and inclusion or a myriad of other objectives. This sort of personal commitment is persistent and much less likely to be swayed by short- and medium-term market rotations.
Marina Severinovsky is Head of Sustainability, North America at Schroders