: ESG funds are ‘going to suffer’ as tech stocks lag and value beats growth

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As value strategies are beating growth in the stock market this year, a number of environmental, social and governance funds are lagging behind the broader market, and some are down sharply.

The losses are especially pronounced in a couple of last year’s ESG exchange traded fund darlings that focused on clean energy, Invesco Solar ETF

and iShares Global Clean Energy ETF
down 29% and 24%, respectively.

As investors worry about inflation, rising interest rates and the impact on long-duration assets, funds that did well when the market rewarded high growth, momentum-based investments are getting burned. Even several broad-based sector-neutral funds that were designed to hew closer to indexes are trailing. Those include the Vanguard ESF ETF
which has a gap to the Russell 1000 of 1.37%, net of fees.

Traditionally many ESG ETFs and mutual funds were tilted to the tech sector and growth styles since technology companies generally don’t emit much carbon, and the funds benefitted from a growth market. Now that value is in style and the sectors it favors, such as energy, materials and industrials, are surging, it may mean a period of underperformance for ESG investors, some investors say.

Right place, right time

Vincent Deluard, director for global macro strategy for StoneX, is skeptical that stock picking helped ESG performance. For a study, he aggregated the 2020 holdings of the largest U.S. ESG ETFs into a composite, finding a heavy sector bias to tech and health care, and an underweight to energy, a combination that outperformed during the pandemic.

However, he says a non-ESG portfolio with the same sector tilts as the composite would have outperformed the S&P 500 Index

by 2% since the start of 2020 through the first quarter of 2021, versus a relative gain of just 80 basis points for iShares ESG USA MSCI USA Leaders

“All of the outperformance of ESG came from being at the right place at the right time, not because of picking better stocks. As we see this rotation to value, ESG portfolios are going to suffer,” he says, although he adds that strong flows into ESG ETFs may soften some of the underperformance.

Rumi Mahmood, senior associate for ESG Research at MSCI, cautions looking at ESG performance over a relatively short term.

“There’s a misconception that as value returns to fair value, if you will, that this signals the demise of all ESG funds,” he says. “ESG isn’t pure growth and pure momentum.”

Mahmood says there are also inherent risk and financial materiality concerns factored into ESG methodologies, and he says the long-term risk-adjusted return, measured by the Sharpe ratio, of ESG funds and indexes on average are higher relative to the non-ESG counterpart.

Financial advisers who run socially responsible and ESG-focused portfolios say some of their portfolios are underperforming the broader indexes this year. Peter Krull, CEO of Earth Equity Advisors, says in the short term he expects ESG investments may see some reversion to the mean.

“Short-term drops like this are natural and you’re going to see cycles like this,” he says.

However, he’s confident this shift to value may be short-lived, if an investor views a value cycle through the lens of carbon-intensive industries such as fossil fuels because he thinks there are structural changes occurring in the economy toward renewable energy and other changes.

Overpaying for growth

A lot of ESG funds caught a tailwind from tech’s outperformance and are lagging now, but Billy Hwan, portfolio manager of the actively managed Parnassus Endeavor Fund
a U.S. large-cap value ESG mutual fund, suggests investors should take a nuanced view.

He says some other ESG fund firms constructed portfolios based on performance and became heavily weighted to top performers such as Apple

or Tesla
companies that also have good ESG ratings. With rising share prices there were generally fewer questions about governance risks.

“And then, on top of that, there’s the really strong incentives to slap ESG on those funds, because that’s where the fund flows are going,” he says.

While his fund is also overweight tech, he says Endeavor’s composition is much different in that it doesn’t hold Amazon

or Facebook
two other common names in ESG funds, and is underweight Apple. Instead, the fund holds firms such as Micron Technology

and Applied Materials

What’s happening now is a reminder that even in ESG, valuation still matters and investors can overpay for growth.

Active ESG funds swapping names

Mahmood says looking at the top 20 ESG indexed ETFs and active mutual funds shows even into 2021 these funds still have a higher weighting to tech, communication services and health care, and less to energy than the average non-ESG fund and the relative positioning hasn’t changed than much since last year.

Yet Ken Van Leeuwen, CEO of Van Leeuwen & Co., which also runs ESG portfolios for clients, says he’s noticed some actively managed ESG mutual funds have responded to the style shift, reducing exposure to some tech names and buying financials. He pointed John Hancock ESG Large Cap Core Fund
which includes Mastercard

and Bank of America

in their top five holdings. Van Leeuwen says banks can score high on governance matters, which is why some ESG funds hold them.

Integrating ESG into all investing decisions and doing it with a value bent can mean excising some sectors. Fossil-fuel-free funds like Parnassus have always shunned traditional energy, and Hwan says even though that sector looks like a value trade, he thinks traditional energy is in secular decline.

Investments can get trickier in other common value sectors such as materials, the home of sometimes environmentally hazardous firms and often left out of ESG portfolios. Utilities are sometimes problematic because of fossil-fuel use, but right now a bigger issue is price, Hwan says. Parnassus also shuns alcohol and tobacco companies, which can cut out a wide swath of consumer staples.

ESG investors may have more luck in industrials, another wide-ranging sector.

“Just because a company is an industrial company doesn’t mean that it’s bad environmental actor,” says Derek Deutsch, portfolio manager of the ClearBridge Sustainability Leaders Strategy
a core blend actively managed mutual fund. He points to Trex
which makes composite decking out of recycled plastic, as an example of an industrial firm the fund owns.

Tough choices

Todd Rosenbluth, director of mutual fund and ETF Research at CFRA Research, says ESG investors may have to make some choices about aligning their values and their investments as the market changes.

Sector-neutral ESG ETFs such as iShares MSCI USA ESG Aware
the biggest ESG ETF by assets under management at $17 billion, is up 9.7% year-to-date, but lagging its benchmark index, MSCI USA, by 0.50 basis points, net of fees.

However, to try to be both broad-based and closely track the index, it also has a small weighting to fossil-fuel producers Exxon

and Chevron
That may make some environmentally conscious investors queasy.

Rosenbluth says those investors need to make a choice.

“Sometimes the investment goals are easily aligned with social goals. But most of the time, you’ve got to make that choice. Do you want to be broadly invested? Or do you want to be more targeted and kick out companies? The more companies you take out of the portfolio, the greater the risk of underperformance when you’re missing out (on a sector),” he says.

Debbie Carlson is a MarketWatch columnist. She doesn’t own any of the funds or stocks mentioned in this article. Follow her on Twitter @DebbieCarlson1.

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