Ask someone if they approve of something nice-sounding and they will almost always say “yes”. So it is with environmental, social and governance (ESG) investing. Survey after survey tells us that most people are mad for it. They want to invest in line with their values. They want to know the companies they invest in care about their staff, communities, suppliers, customers and the climate. They consider (they say) ESG whenever they choose an investment. But here’s the problem (or the problem for ESG-labelled funds anyway): investors consider ESG, but lots of other things matter too.
A survey from the Association of Investment Companies shows that, given five criteria by which to judge an investment (performance, cost, ESG factors, the fund manager’s reputation, and the asset manager’s reputation), investors put ESG at the bottom – by some way. ESG gets an average importance score of 3.4 out of five. All the others come in over four, with performance top at 4.5. I am sure lots of people will argue that this is a silly way to do it. Some of the other things are clearly a function of ESG. The fund manager and the business he works for will only have a good reputation if their governance is good, for example. Remember Woodford? Quite.
There is also a view that ESG funds will automatically deliver better performance – as they appear to have over the last decade. So if you care about performance, you should be buying ESG funds anyway.
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I’m not yet convinced. ESG’s apparent outperformance has only happened since around 2013 (to be fair, the ESG universe was pretty small before then), a period in which the types of stocks that often end up in ESG portfolios (technology and quality) have outperformed. There’s also been a hefty liquidity effect: as money has poured into the sector, ESG-eligible shares have been bid up and up. Neither of these things are necessarily sustainable – there is an obvious bubble brewing in renewables and there has also been very obvious outperformance from a sector most ESG funds actively avoid (fossil fuels) recently. It wouldn’t take much for the sector’s apparent outperformance to turn into rather nasty underperformance.
That could be a problem (particularly given that Mark Carney’s deal with financial institutions on net zero has effectively defaulted an awful lot of everyone’s cash into a vague but vast ESG fund). ESG investors have so far been able to have their cake and eat it (do-goodery plus returns). If that changes, inflows could fast turn into outflows.
The key to working around all this (given that we all want to help the planet) is to look for “cake and eat it” possibilities in the less crowded and less obvious areas of the market. In this week's magazine we look at the biodiversity sector, which is slowly becoming less overlooked; investments in soil may be a big part of the future. And check out Mike Tubbs’ list of nine stocks to buy and hold for ever. There is no reason any of them couldn’t make it into a standard ESG portfolio. Finally don’t forget nuclear power and of course fossil fuels. They aren’t in favour with the COP crowd, but we will need them for a long time to come, there is plenty of money to be made and, crucially, there is also a kind of moral high ground in being able to step back from the demonising and recognise the huge social value in keeping the lights on. There is a lot of focus on the E in ESG. The S is pretty vital too.
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