ESG put to the test in a high-inflation world

After more than a decade on the investment scene, ESG is being put to the test as never before.

The past 18 months have exposed the short-term risks of sustainable funds. Many missed out on the oil price surge in 2022, raising questions not only about their short-term performance but also their long-term strategy in a world that might need fossil fuels for longer than people had hoped. 

Meanwhile, growth stocks — favoured by many environmental, social and governance fund managers — have proved volatile in the face of inflation and rising interest rates. And regulators are probing claims of greenwashing amid doubts over whether many sustainable funds are sustainable at all. 

“People’s concerns about whether it’s the right thing to do definitely come closer to the surface when they’re underperforming,” says Iain Barnes, chief investment officer at wealth manager Netwealth.

Very few investors think that sustainable investment is just a fad. With the energy transition supported by many governments around the world and a greater awareness that well-run companies are less risky for investors, investing with environmental, social or governance factors in mind is evolving rather than disappearing.

But building a sustainable investment portfolio requires more care than it did in recent years. Higher interest rates and uncertain market conditions mean investors are no longer able just to place all their bets on growth stocks. And to avoid greenwashing, investors should make sure they know exactly what is in their funds.

Price rises and growth

Inflation has not been kind to many sustainable funds. As investors worried about rising prices from the start of 2022 and interest rate rises began to kick in, they pulled money out of growth stocks around the world, which suffer when rates are higher. 

That was bad news for sustainable funds, many of which were packed full of tech companies, which traditionally sit in the growth sector. This was in part because they tended to be relatively short on oil and gas stocks — for obvious reasons — leaving them with the rest of the stocks in their benchmark index to choose from. 

Morningstar notes that while ESG funds remained popular with investors, as measured by the amount of money flowing into them in 2022, they tended to underperform their traditional counterparts, with just 41 per cent in a sample study outperforming their traditional peers. The MSCI World SRI index lost 22 per cent last year, compared with just 17.7 per cent for the MSCI World index, the first year since 2015 that it had underperformed its traditional counterpart.

Over a longer time horizon, ESG funds did still outperform, with 56 per cent doing better than traditional peers over a five-year period. Morningstar suggested this was evidence that investors don’t necessarily give up performance when investing sustainably. But as sustainable funds were riding on the outperformance of tech and other growth stocks during that period, this is an uncertain guide to the future. The question for investors is how sustainable funds will fare in the new economic environment. 

Where now?

One tip from fund managers is to build a core portfolio with satellite options around it that can be invested in higher-risk areas. For example, Dominic Rowles, an ESG analyst at Hargreaves Lansdown, recommends a global tracker fund like the L&G Future World ESG Developed Index or, as a more conservative option, the BNY Mellon Sustainable Real Return fund, which avoids companies incompatible with the aim of limiting global warming to 2°C. 

A satellite option could be WHEB Sustainability, which looks at themes such as sustainable transport and wellbeing, but is very different from the broader global stock market. 

Another approach is to protect your portfolio by making sure it isn’t too overweight in certain sectors. The Rathbone Greenbank multi-asset portfolios, for example, avoid having a large growth or tech bias. 

Rahab Paracha, a sustainable specialist at Rathbones, says: “We aren’t interested in getting pulled into the hype and investing in more speculative growth areas, many of which raced away during the pandemic but have seen significant weakness over the past year as interest rates have gone up.” Instead, she says, they look for quality companies which have strong management, financial discipline and sensible levels of debt.

Investors can also build a sustainable portfolio using passive funds. Barnes at Netwealth, which runs passive sustainable portfolios, says it is important to identify passive ESG funds that actually add value rather than just excluding certain companies. On that basis, Netwealth constructs portfolios using the MSCI SRI indices, which target companies that have the highest ESG ratings.

Sophie Westwood and Laura Longley, investment managers at Evelyn Partners, reckon that even though market conditions are very difficult now, there are still “fantastic opportunities” for ESG investors. 

“A common misconception is that all ESG funds are super growthy, full of unprofitable technology stocks and renewables, but this is not the case. There are a plethora of funds with a core or value style bias, which invest across the spectrum of responsible capital,” they argue. 

Thematic funds such as the Schroder Energy Transition Fund are also worth a look, they believe. Usually global equity funds, these will focus on certain areas such as the energy transition or artificial intelligence. They think the dramatic derating on stock markets last year has created opportunities to pick up great businesses at attractive valuations. 

Many investors think the US Inflation Reduction Act will help sustainable stocks to do well over the coming years. Rathbones holds two US companies that should benefit from the rising demand for more sustainable buildings: Owens Corning, which provides building insulation; and Advanced Drainage Systems which is focused on stormwater management infrastructure.

Beyond equities

While most of the focus in sustainable investment is on equity funds, investors looking to construct a sustainable portfolio should look at other asset classes too. Some argue that investors can have more impact by investing in bonds, for example, because these can finance specific projects at companies. 

Westwood and Longley at Evelyn point out that with many government bonds now yielding more than 5 per cent, investors can get a decent yield on a safe asset, which is not something they’ve been used to in the past decade. Most of their sustainable clients are comfortable holding government bonds, they say, but because you cannot determine how a government uses the proceeds, it is always worth checking. 

The green bond market, where proceeds are used to finance environmental or renewable projects, has grown in recent years in the US and Europe, but is still in its infancy. “We’d hope this area to have a more significant place in sustainable portfolios in the future,” they say. One bond fund they like is the Aegon Short Dated Climate Transition Fund. 

Other investors swerve government bonds in sustainable portfolios — Rathbones, for example, does not use US Treasuries because bonds have to meet certain levels on climate change, defence, civil liberties and corruption. Instead, they look for bonds that are more targeted, such as a sustainable bond issued by New South Wales in Australia, with all proceeds used to finance projects that improve the environment and society. Rathbones has also bought a green bond from German development bank KfW which has the advantage of being denominated in Norwegian krone, offering some protection from oil-induced inflation.

Interactive Investor, a UK investment platform, recommends that novice investors check out the CT Sustainable Universal MAP range of multi-asset funds, offering “cautious”, “balanced” and “growth” options. Those comfortable picking their own funds can look at the platform’s ACE 40, a list of sustainable funds selected by its team with the aim of helping investors construct a global portfolio with an ethical overlay.

Sometimes it’s hard to match assets in a sustainable portfolio with a traditional counterpart. Barnes at Netwealth says it is difficult to find an asset that behaves in the same way as commodities, which the platform avoids in its sustainable portfolios due to concerns over the environmental and social impact of mining. Instead, they hold cash, in spite of its effect on returns, which they felt was “the least bad way” of adjusting the sustainable portfolio. 

Greenwashing fears

It is all very well suggesting a balance of funds that are not too growth-focused and focus on a range of asset classes and regions, but how can investors tell whether they are actually sustainable? 

There has been a spotlight on so-called greenwashing, where companies and investors pretend to be more environmentally friendly than they really are, with regulators in the US handing out their first fines to fund managers last year and the UK regulator, the Financial Conduct Authority, planning an overhaul this summer. Its new rules are expected to result in the number of funds allowed to be labelled as sustainable slashed to just one-third of the existing range. 

Investors should always check the top 10 holdings of whichever fund they are considering, rather than just thinking that “Sustainable Leaders”, “ESG Aware” or whatever name the fund manager has picked sounds good. Looking under the bonnet of a fund tends to yield surprises: a sustainable fund might have oil companies that are considered “best-in-class”, such as BP, or tech stocks that appear to have nothing to do with saving the planet. 

It should also be possible to find out whether fund managers have a record of engaging with the companies they invest in. They should be willing to provide examples of times they have voted against a company and why or when they have pushed for more sustainable targets to be met. 

In for the long haul

While rising inflation and interest rates, the war in Ukraine and the energy crisis have shifted sustainable investing down the agenda for some people, the overwhelming view of professional investors is that the longer-term drivers of sustainable investment remain intact. 

Yet for all the talk of sustainable investment taking off, more product choice and greater transparency is still needed for many investors to feel comfortable with it. At Netwealth, for example, just 4 per cent of clients are in sustainable portfolios. 

Dzmitry Lipski, head of funds research at Interactive Investor, points out that a lot of sustainable funds have launched recently so are relatively small with short track records, while in some key sectors like equity income there is still limited choice for retail investors. 

But greater regulation is expected to play a key role: with the Financial Conduct Authority set to tighten the rules on what counts as sustainable, retail investors should be able to understand exactly what it is they are buying. The turmoil of the past 18 months has arguably been helpful for the sustainable investment sector over the long term in exposing problems with many funds and the ways in which fund managers were making returns simply by piling into growth stocks. That is no longer an easy way to outperform, while the case for the energy transition has become stronger. For investors willing to do a little extra legwork, robust long-term sustainable portfolios look more attainable.