ESG funds weather the worst of the recession, but investors are spooked

The market slump is testing the resilience of ESG funds and their shareholders.

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(Bloomberg) — For sustainable investors browbeaten by the recent attacks on the industry, fund performance may offer a bit of reprieve. 

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In three broad categories – Europe-focused, US-focused and global – ESG equity funds have done better this year, on average, than their non-ESG counterparts. All are negative, in line with the market selloff, but ESG funds are less down than the others, despite generally tech-heavy and low-energy portfolios.

ESG proponents insist that using environmental, social and governance metrics in investment decisions can drive returns – or at least won’t lower them. Others are not so sure. The rapid growth of ESG funds coincided with a bull market that ended in 2022, making this lull a test for portfolio managers and investors.

“For the first time in a long time, ESG companies are going to be at the mercy of the market, not at the mercy of ESG,” said James Penny, chief investment officer at TAM Asset Management. Until now, “you could have bought any ESG fund and that would have done the trick, but because of the environment you have to do it from scratch and earn your corn as a manager.”

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Investors are shaken. The market crash in May was accompanied by record ESG outflows. Investors withdrew $2 billion from ESG-labeled exchange-traded equity funds, according to Bloomberg Intelligence. In terms of assets, funds focused on environmental, social and governance factors are down 20.5% since the start of the year, slightly more than the 19% drop in general funds, according to the data compiled by Bloomberg.

ESG investors also pay higher fees for their investments, creating an additional test for returns. For stock index funds — typically marketed as cheap and easy to access — ESG investors pay more than double the average for stock index funds, according to data from analyst firm Morningstar. (Actively managed ESG funds cost about the same as their non-ESG counterparts.)

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Investors might be happy to pay more when returns are good. But priorities change in turbulent markets. In an RBC survey of 900 U.S.-based investors, nearly half said financial performance and returns were more important than ESG impact, up from 42% who said so last year. In a separate investigation, Charles Schwab Corp. found that 66% of retail investors in the UK don’t care if their allocations are sustainable and instead want to maximize their profits.

Investors are currently focused on the short term, Penny said. “You have rising interest rates. You have a cost of living crisis. Investors are much more concerned with not losing money than with gaining 10% or 20%,” he said.

Tech stocks accounted for a quarter of global ESG fund holdings at the end of April, more than their non-ESG counterparts, according to fund analytics firm EPFR, and sector returns have fallen by around a third this year. The largest ESG-labeled ETF, BlackRock iShares ESG Aware (ticker ESGU), has 28% of its portfolio allocated to technology; it has lost 24% this year.

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At the same time, ESG funds tend to avoid or minimize exposure to energy stocks, so they missed out on the recent commodity boom.

More troubling is the long-term performance of ESG funds. Global ESG funds have underperformed the broader market over the past five years, returning an average of 6.3% per year, compared to 8.9% for broader funds, according to data compiled by Bloomberg. An investor who invested $10,000 in an average global ESG fund in 2017 would have $13,573 today, about $1,720 less than if they had placed it in a non-ESG portfolio.

The same is true for investors in funds focused on the US and Europe. US ESG funds have returned an average of 10.2% annually, compared to 12.6% for broader funds; European portfolios grew by 3.8% per year on average, slightly less than the 4% average annualized return of non-ESG offerings.

For now, there is still enthusiasm for ESG, said Paulo Salazar, co-head of emerging markets equities at Belgium-based Candriam. “I don’t see the ESG trend being impacted” by this slowdown, he said. “Interest continues to be very high.”

At the same time, it might be good for investors to realize that ESG stocks are also subject to market gravity, said Duncan Lamont, head of strategic research at Schroders. “But the long-term structural drivers [for sustainable investment] are really there.

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