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BLOG: ESG funds can be just as risky as regular equities

Written by: Edward Glyn
The ESG sector is a worldwide phenomenon and it’s held up well in the face of widespread investor fear. But ESG funds are not inherently any less risky than regular equities, but are coming from a very low base.

The UK’s ESG boom took off in earnest in late 2019 as the trickle of investor interest that had begun in 2018 turned to a flood. As fund management sales teams spotted the emerging trend, new funds were launched and marketing spend was focused on a nascent sector, spreading awareness and increasing demand ever further.

Funds saw average monthly inflows of £63m in 2019 expand to £930m during 2021 making them by far the most successful investment trend of the last few years.

The figures are huge – between the beginning of 2019 and August 2022, ESG equity funds have raked in a net £20.5bn of investor capital, compared to a net outflow of £850m from all other kinds of equity fund, thanks mainly to heavy selling in out-of-favour categories like UK and European equities and, at least until recently, income funds.

We have seen similar patterns play out across our global network, though with slightly different phasing. ESG is certainly a worldwide phenomenon.

ESG not immune to the 2022 markets turmoil

2022’s bear market reflects the necessary re-emergence of risk as a differentiating factor in markets after years of sedative central-bank money printing. Inflation, war, supply-chain snarl-ups and the energy crisis are all part of the picture.

It has been especially painful for non-ESG funds in the UK; they have suffered heavy outflows of £7.9bn between January and August. ESG has not been immune to the turmoil. Although ESG funds have continued to attract new capital (£3.6bn), the rate of inflows has slowed markedly, down to just £95m in August, the worst month in three years.

ESG funds are not inherently any less risky than regular equity funds, with a similar sector mix so their relative success gathering 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 socialised rather than borne by the companies themselves – climate change or worker exploitation are two examples.

The growth profile or income generation of companies with good ESG credentials is likely to be quite similar to other kinds of companies, once sector differences are allowed for. If anything, the relatively heavy weighting to technology companies that more easily meet ESG criteria pushes up risks at the portfolio level.

The key point is that ESG is coming from a very low base – assets under management remain a tiny fraction (less than 4%) of equity funds overall – and it is in a clear structural growth phase. That means there is both a strong bias among investors towards buying, and also a relatively small pool of assets that could suffer selling activity. This explains why fund flows have held up so well this year in the face of widespread investor fear.

ESG tensions bubbling to the surface

There are some tensions bubbling to the surface that may slow the medium-term progress of the ESG fund industry, however.

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 last five years, returning 6.3% on average. A relative underweight in energy stocks that are making out like bandits at present is surely hurting returns this year.

This has not deterred the early adopting investors, but increasingly it will come to matter as the category goes mainstream.

Longer term, from a capital asset pricing perspective, if assets that don’t make the ESG cut come to trade consistently at a large discount, then they are likely to offer superior returns to their investors, unless regulation or taxation raises costs for such companies and so reduces their value. These forces of financial gravity would inevitably slow the tide of capital flowing to ESG eventually.

The second problem relates to selection criteria. A company deemed acceptable by one fund manager may be out of the question for another so how is a fund investor to know what she is buying? Equally, how do you treat companies that are in transition – for example, at what point does a legacy oil producer building its renewable energy business get credit for that enterprise? This thorny question is greatly exercising fund managers at present. Moreover, blurred lines and accusations of greenwashing have spurred a backlash against ESG in the last year or so.

Public sees ESG as a ‘moral exercise’

Finally, there is a structural defect, identified by Stuart Kirk, formerly head of sustainable investing at HSBC. It is related to the second point above. He points to the fact that ESG has two meanings – the first is that to understand the risk-adjusted returns of a company, you have to take environmental, social and governance issues into account.

This is key to fund managers assessing investments, and will drive the ESG score of a fund, but it is not what the public understands by the term. It allows any company to be in a portfolio as long as the risks from its polluting or poor governance are reflected in its price.

By contrast, the public sees ESG as a moral exercise of using the power of capital to ‘do the right thing’ and effect positive change. Kirk argues this disconnect will hamper the development of the industry. It is probably at the root of the greenwashing question too, if you think about it.

I do not think these problems are fatal. The fund management industry is enormously creative, adaptable and responsive to investor needs.

A proliferation of sub-themes and impact investment like ‘renewable energy’ (currently selling like hot cakes across Calastone’s network), for example, helps hone investor expectations of a fund and the manager’s investment process. And if the issues are not solved, regulators will roll up their sleeves and get involved, especially as the category gets larger.

To my mind, this is a communication issue first and foremost. Clarity about the fund mandate and investment process should help investors make the right choice.

I am optimistic for ESG. It continues to attract capital in the worst economy since the global financial crisis, suggesting that it can grow long-term too.

ESG has stolen the show in the last three years and still has plenty of curtain calls to come.

Edward Glyn is head of global markets at Calastone

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