The ESG funds making a comeback

The past few years have held many lessons for funds investing with an environmental, social and governance (ESG) tilt. The higher-rate era has exposed the limits of the idea that investing sustainably is a sure way to achieve above-average returns. It is clear now that those returns are not assured: not regularly, or at least not yet.

Given the impact of climate change is becoming ever more visible, many investors will not unreasonably view these returns as a secondary priority. Even so, there are still reasons to ask whether ESG funds are equipped to meet their expectations.

In the short term, there have been two principal reasons for the sector’s struggles. On a relative basis, there is the outperformance of both defence and fossil fuel shares in light of Russia’s invasion of Ukraine. More fundamentally, higher interest rates make upfront costs more onerous for a range of different sustainably-minded businesses.

These costs are not an impediment to every strand of sustainable investment. Years of subsidies for solar power, for example, are now paying off via a step-change in demand across the globe. And yet, as the struggles of many renewables-focused investment trusts illustrate, capitalising on these shifts is not as simple as it looks.

Still, from a fund perspective, the underperformance of ESG assets has played out more subtly than one might expect. Since the start of 2022, the average return from 2,000 open-ended funds listed in the Investment Association (IA) equity sectors is 5.5 per cent. In a sign of asset managers’ embrace of ESG as a marketing tool, fully 400 of this group are now classified by data provider FE as ethical or sustainable in nature. The average return of these funds is not much lower, at 3.8 per cent.

To discover why, consider sustainable portfolios’ favoured sectors. Their remits may have prevented them from buying into defence and energy shares, but in practice that often means tilting even further towards the most popular trade of all: tech stocks.

Benchmarks illustrate this shift. Some 18.5 per cent of the MSCI World index is held in Microsoft, Apple, Nvidia, Amazon, Meta and Alphabet.

That percentage rises to 22 per cent for the iShares MSCI World ESG Screened ETF (SAWD), and is the principal reason why the ETF has narrowly outperformed its unscreened equivalents over recent times.

This, though, is hardly a cause for satisfaction. Those wanting more concentrated exposure to technology shares already have an array of funds – active and passive – to choose from. And investors who are seeking a genuinely ethical or sustainable offering may have just as many qualms about big tech these days as they do about sectors such as tobacco or gambling. From privacy concerns to AI-fuelled energy usage and monopolist practices, it’s easy to see a would-be sustainable investor turning their nose up at big tech, too.

Doing this, if you’re an ESG fund manager, comes with big risks. Baillie Gifford Positive Change (GB00BYVGKV59), a sustainably minded fund whose five-year return numbers are still flattered by its runaway performance in 2020, shows little sign of turning the corner.

Despite holding almost 17 per cent of its portfolio in Taiwan’s TSMC (TW:2990) and Dutch chip lithographer ASML (NL:ASML) alone, the portfolio is down 2 per cent this year versus an average return of 8.6 per cent for all funds in the IA Global sector. Like the similarly struggling Keystone Positive Change Investment Trust (KPC), which the Baillie Gifford team took over in early 2021, it holds none of the Magnificent Seven that are driving US and global equity market returns. It’s been similarly tough going in 2024 for a number of other popular sustainable global equity funds. Returns in the year to date have been sub-par, albeit in positive territory, almost everywhere you look.

 

The funds bucking the trend

In fairness, comparing these portfolios with an AI-driven market is a high bar. Several global sustainable portfolios have posted returns of between 7 and 11 per cent thus far this year – more than enough by any reasonable expectation. They include Pictet Global Environmental Opportunities (LU0503632878), EdenTree Responsible and Sustainable Global Equity (GB0008449075) and Stewart Investors Worldwide Leaders Sustainability (GB0030978729).

The EdenTree fund has a combined 10 per cent in Microsoft and Alphabet, but otherwise the tech giants are conspicuous by their absence. A fund with a shorter track record, Royal London Global Sustainable Equity (GB00BL6V0581) (launched in 2020), has done even better, notching up double-digit returns this year and last.

The Stewart fund, in keeping with the manager’s general emerging markets focus, differs from most global rivals in that it is significantly overweight India, which accounts for 14 per cent of the portfolio compared with its negligible weighing in most global indices. The flipside is that its US exposure, at 45 per cent, is just two-thirds of the regular global fund’s position.

Pictet Global Environmental Opportunities might be seen, on the surface, as the most green-friendly fund of this cohort. Its top positions are a mix of waste management shares (such as top holding Republic Services (US:RSG)) and those that have been given a new lease of life by the AI boom such as Eaton (US:ETN), an electrical equipment maker whose shares have risen a third this year alone on rising demand for its products from data centres.

Another climate-minded fund, Ninety One Global Environment (GB00BKT89K74) – hitherto one of the most popular ESG funds among professional investors – favours a similar mix of top positions.

But it’s showing little sign yet of recovering its poise post-2022. Its largest positions also include waste management, and its top holding, US renewable power provider NextEra Energy (US:NEE), has also seen shares bid up by 20 per cent this year as tech giants seek ways to build more data centres.

But the fund’s positions in European wind power plays Orsted (DK:ORSTED), Vestas Wind Systems (DK:VWS) and Iberdrola (ES:IBE) have been less resilient. Given the high initial costs incurred by wind projects, expansion has proved difficult for these businesses since rates started to rise.

While big tech’s power means none of these portfolios have got close to the MSCI World’s 39 per cent return since the start of 2023, they have all (other than the Ninety One offering) outperformed the average active fund performance of 23 per cent over the same period.

This 18-month timeframe feels appropriate when assessing ESG-tilted strategies: none came out of 2022 looking good, given the perfect storm of commodities and defence shares rallying, and growth (including technology) shares being hit by higher borrowing costs. It hasn’t been plain sailing since for the sector – base rates have gone higher still, after all. But this more select group has managed to put in a creditable performance.

 

The domestic picture

Looking at ESG-focused UK equity funds presents a different challenge for would-be investors. These portfolios are largely unencumbered by the need to keep up with runaway tech shares (at least as far as their benchmarks are concerned). By the same token, the absence of these leading lights means there are fewer easy wins for funds that must by design shun a large part of the UK market.

Of the biggest domestic portfolios, the Royal London Sustainable Leaders Trust (GB00B7V23Z99) remains a relative standout.

It is one of only a handful of sustainable funds to have outstripped the FTSE All-Share since the start of 2023, and its method for doing so is instructive.

Its positions in companies including Relx (REL) and Experian (EXPN) have aided returns, and these companies and their ilk are also found among the 10 largest positions of other outperformers such as Aegon UK Sustainable Opportunities (GB00B1N9DS91) and Aegon Ethical Equity (GB0007450884).

The latter, which takes a stricter view on holdings and so excludes sectors such as pharmaceuticals, has generally eked out slightly higher returns by doing so. For income investors, Janus Henderson UK Responsible Income (GB0005030373) has produced similar if steadier returns with a historic yield of 4 per cent.

There is one final area of notable outperformance that will chime with UK investors, even if most of the shares involved are listed elsewhere.

The L&G Clean Water ETF (GLGG) has returned 27 per cent since the start of last year, putting it in the upper echelons of sustainable open-ended funds over that timeframe.

Over half the fund is held in US shares, with a tenth in Japan and another tenth in the UK. Some of these UK positions, however, may not be businesses that spring to mind at the moment as far as water cleanliness is concerned.  They included, as of latest disclosure dates last summer, Pennon (PNN), Severn Trent (SVT) and United Utilities (UU.).

These companies are well within the fund’s remit: it holds, among other things, utilities that derive at least 90 per cent of their revenue from water. But their presence underlines for investors to do their own research. Matching ESG funds’ preferences with investors’ own is a longstanding issue for the sector that’s unlikely to be resolved any time soon.

Some ESG equity funds have recovered creditably from 2022
		Returns (%)
	Since start of 2022	1 year	3 years	5 years
Royal London Global Sustainable Equity	36	22.6	30.4	na
Stewart Investors Worldwide Leaders Sustainability	26.3	17.3	26.1	58
EdenTree Responsible & Sustainable Global Equity	25.1	12.6	10.2	43
Pictet Global Environmental Opportunities	23.4	17.2	19.5	71.6
IA Global sector	22.4	17	17.3	54
MSCI World	39.4	23.8	27.7	50.9
Aegon Ethical Equity	22.3	20.5	-0.5	46
Aegon UK Sustainable Opportunities	19.9	19.9	-7.9	22.2
Royal London Sustainable Leaders Trust	18.8	13.5	-15.5	46
IA UK All Companies sector	15.5	14.2	9.5	25.4
FTSE All-Share	17.5	15.7	24.4	33.1
Excluding funds with significant positions in big tech. Source: FE, as at 24 June 2024