ESG investors play the long game

ESG is no longer the buzz phrase it used to be for private wealth managers. 

Until last year, boasting about the quality of environmental, social and governance funds was a key way to get new client money in through the door. The story was strong: as climate change generated increasing concern, ESG funds were better positioned for the future.

The performance was also strong: many such funds merely operated on an exclusion basis, ditching oil and gas stocks and ending up overweight in tech and other growth stocks.

For much of the past decade, with low interest rates and inflation, that meant ESG funds performed at least as well as traditional equity funds, if not better. Sustainable investors were told they could have their cake and eat it. 

Then 2022 happened. Oil and gas stocks surged while tech and growth stocks tanked, driven by the Russia-Ukraine war, higher inflation and rising interest rates. For the first time in a decade, ESG funds had net outflows, according to data from Refinitiv-Lipper.

ESG also became politicised — in the US, Republicans with ties to the oil industry began a backlash against the term that has made even global companies nervous about pushing their ESG credentials too much. As for regulators, companies have faced fines for greenwashing in the US, and the UK is planning a new definition of sustainable funds this summer that will see the universe forced to shrink to about a third of its current size.

But while the performance of ESG funds has been hit — at least in the short term — does the story still hold strong? 

It is not rocket science to suggest that companies that have poor scores for E, S and G tend not to make fantastic investments over the medium to long term

One development is that the definition of sustainable is being refined, partly due to scrutiny by regulators. ESG has been used as a synonym for sustainable; no longer. The UK’s Financial Conduct Authority plans to draw a line between funds that simply exclude certain sectors or stocks, and those that invest in actively sustainable companies. While this will lead to fewer funds allowed to call themselves sustainable, the additional clarity will make the sector more transparent, analysts believe. 

“Not only will clearer guidelines and rules make it easier for companies, but clearer labelling and disclosures will make it easier for consumers too,” says Tara Clee, ESG analyst at Hargreaves Lansdown. 

She says the next big challenge for regulators is to ensure there is more global alignment on ESG standards: “Too much divergence of ESG standards brings the validity of all ESG claims into question.”

Greater awareness of the different types of these investments also means retail investors are being more strategic. Iain Barnes, chief investment officer at Netwealth Investments, says client interest now falls clearly into two camps. Those interested in sustainable investment tend to put the bulk of their money into multi-asset portfolios with carbon reduction as a goal. Barnes says a portfolio like this can help them achieve their financial objectives, who then put a smaller amount into more personal “impact” investments. 

Another way to use ESG is as a way of sifting out companies that may not be great longer-term bets. 

“It is not rocket science to suggest that companies that have poor scores for E, S and G tend not to make fantastic investments over the medium to long term,” says Rob Burgeman, senior investment manager at wealth manager RBC Brewin Dolphin.

While clients and their wealth managers may understand the nuances of ESG investment better as a result of last year’s setback, overall ESG investment looks only set to grow in the medium term. A report from PwC in October found that asset managers were expected to increase ESG-related assets under management to US$33.9tn by 2026, from US$18.4tn in 2021 — an increase of 84 per cent. 

The reason for this is likely to be that despite recent setbacks, the long- term story for ESG remains strong. The energy crisis has focused minds on the need for a transition away from fossil fuels, while the focus of regulators on greenwashing means sustainable funds will have to work harder to earn the label. 

Nick Murphy, a partner at Evelyn Partners, says: “Despite recent setbacks, we anticipate an acceleration in investment in carbon emission reduction and an opportunity for investors who are keen to promote it. In the developed world this is led by the US Inflation Reduction Act and the enormous level of investment required to achieve such an undertaking.” 

Burgeman says diversifying is the best option for investors among all the different approaches to ESG.

“ESG investment comes in 50 shades of green and the issues it seeks to address are far broader than simply climate change, and range from social inequality to empowerment of women to food production to water scarcity, all the way to the more traditional drive to carbon neutrality. It has been and is likely to remain one of the driving factors for investment for the foreseeable future.”

Alice Ross is an FT contributor. Her book, “Investing to Save the Planet”, is published by Penguin Business. Twitter: @aliceemross