The scramble for funds screened for Environmental, Social and Governance scores appears to be paying off in the strange pandemic-hit world of 2020 – but it may also be aggravating long-standing market skews.
On the face of it at least, ESG-themed equity funds that claim to locate more firms based on criteria such as carbon intensity, staffing diversity and shareholder control are having a good pandemic. Fund inflows are surging and performance is at least keeping pace.
Two of the myriad global indices now tracking the booming investment trend have outperformed MSCI’s all-country stock index so far this year. MSCI’s own “World ESG Leaders” has outstripped the all-country by about 2 per cent while the FTSE Russell FTSE4Good Developed 100 outpaced it by 5 per cent, up to mid-October.
That’s hardly surprising on one level. Funds set up to avoid carbon-energy firms or banks, for example, will have avoided the worst sectoral laggards in one the deepest recessions in modern history.
Amplifying that advantage, they are also typically loaded up with younger digital and technology firms that have led the stock market in recent years and have been supercharged by pandemic lockdowns, remote working and online retail.
The FTSE4Good Developed index, for example, has a 22-per-cent weighting in technology firms – not to mention a further 5 per cent in telecoms and media and a hefty 13 per cent in health care. And perhaps predictably, its top three holdings – amounting to a whopping 15 per cent of overall weight – are Apple Inc., Microsoft Corp. and Alphabet Inc.
All its stock in oil and gas, basic resources, banks and travel and leisure sectors comes to a little more than 10 per cent.
Paul Surguy, head of investment management at U.K. fund firm Kingswood, reckons a world working from home and a collapse in global travel was always going to flatter carbon-light portfolios.
“Couple this with an ever-increasing use of technology, which is primarily lower-carbon intensive, and one can see why the E of ESG has driven market returns year to date,” he said.
But while an outperformance against the MSCI all-country is impressive, the index has done no better than the S&P 500 and has underperformed the tech-heavy Nasdaq by more than 20 per cent.
To be fair, stretch time frames back over one or two years and it does beat S&P 500, and outperformance per se is not strictly the sole goal of these funds.
But a question for many strategists is whether the ESG boom is itself perpetuating sectoral skews within stock markets that have seen the market laggards such as banks – or so-called “value” stocks persistently shy of historical valuations – underperform growth stocks like the runaway success of Big Tech.
Morningstar data show that almost 200 global large-cap ESG equity funds in Europe had an average tech exposure of 23 per cent in August – up about four percentage points from January.
Looking more narrowly at European climate-specific funds, research into five such funds by investment analysis firm Style Analytics showed a bias toward small-cap, higher-volatility and momentum stocks and away from value and yield.
“Someone who buys these climate funds is getting a factor bias, whether or not they know it and whether or not they want it,” the report concluded.
The report underlines that the ESG trend has been yet another force exaggerating the persistent and gap between value and growth stocks.
“Beyond the falling bond yields and the widening profitability dispersion across European sectors, we believe the rapid rise of ESG investing has also contributed to the Growth/Value polarization,” Barclays strategists wrote.
“Demand for ‘ESG-compliant’ stocks is growing fast, and while overall equity flows have been mostly negative for the past two years, ESG funds have seen record inflows,” they said, adding that the share of ESG funds in total Europe equity funds assets under management had almost tripled to 9 per cent since early 2019.
Some say the total amounts of money involved in ESG are still just too small to make a decisive difference to the outperformance of Big Tech with market caps in the trillions.
But the scale of the growth in these funds is significant on the margins at least. Using EPFR data, Barclays shows cumulative inflows to ESG-labelled equity funds so far this year has topped US$100-billion already – almost 20-percent-up on last year.
ESG funds as a share of the overall universe have more than doubled in fewer than three years to about 3.5 per cent of all equity funds and about 5 per cent of all global funds.
Many asset managers who have watched a doubling of Big Tech share prices in just 12 months are itching to rotate sectors – not least with the gap between the growth and value stocks' share of the MSCI World at its widest since 2000.
But the growth of ESG funds – along with central banks and a second wave of the pandemic – continue to act against that.
What tips the balance? A vaccine to “normalize” the economy? Or a Democratic victory at the U.S. election and a European push to hasten a clampdown on Big Tech’s dominance with tax and antitrust concerns that question their S and G in ESG?
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