ESG funds don’t tell the whole story

Environmental, social and governance funds have had a tough slog this year. In the first quarter, ESG funds globally endured one of their largest cash outflows. The political attacks on ESG in the US have prompted some investors to second-guess the strategy.

But when it comes to investment performance, new data shows that ESG funds had a strong run in the first half of this year, thanks largely to their big holdings of technology stocks.

Most ESG funds that don’t specifically invest in renewable energy businesses are overweight in technology companies and underweight in oil and gas stocks. In the first six months of the year, the S&P 500 gained about 15 per cent. Almost 60 per cent of the gain for the year to date was driven by five tech giants — Nvidia, Microsoft, Amazon, Meta and Apple — which are almost always the largest holdings in ESG funds, according to Morningstar.

Vanguard’s US-focused FTSE Social Index fund, which has US$20.6bn of assets under management, rose in value by 15.5 per cent in the first half and is up 26 per cent over the past 12 months, compared with 24.9 per cent for the S&P 500. Its largest holdings are Microsoft, Apple and Nvidia.

The best performing big ESG fund in the first half of the year was the Putnam Sustainable Leaders fund, which is owned by Franklin Templeton. The fund jumped 19.4 per cent in the first half. Unsurprisingly, its top holdings are Microsoft, Alphabet and Nvidia.

Katherine Collins, a portfolio manager on the fund, said Big Tech was not the only thing powering returns this year. “It is not an Nvidia-only story,” she told me. Companies like Boston Scientific and Eli Lilly also drove outperformance, she said.

To beat an index, stock pickers need an analytical edge, Collins said. Putnam’s view is that “sustainability issues are increasingly important to the operations of the businesses we are invested in and they are structurally under researched”.

Not all big ESG funds beat the wider market. BlackRock’s iShares ESG Aware fund, which does not invest in tobacco, thermal coal and other polluting businesses, slightly underperformed the S&P 500, with a gain of 14.4 per cent so far this year. Nvidia is now its biggest holding, up from fourth at the start of the year.

The world’s largest ESG fund by managed assets — Parnassus’s core equity fund — is up 12 per cent this year. Nvidia again was the third-largest holding.

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Nvidia deserves a reputation as a sustainability leader in part because its chips beat competitors on energy efficiency, Andrew Choi, a manager on Parnassus’s core equity fund, told me. Though Nvidia’s chips are expensive, “there is a reason why their customers are buying it: from an energy perspective, it is the most efficient way to train [AI] models”, he said.

“For us, we are continuing to hold a large position in Nvidia and we don’t think the momentum is really going to let up until maybe some time next year.”

The caveat for the actively managed ESG funds is their fees. The Putnam fund includes a 0.92 per cent expense ratio and might also incur other fees. Parnassus’s fund includes a 0.82 per cent fee. These costs raise perennial questions about what ESG is offering versus low-cost passive funds if their top holdings are virtually the same.

But for investors willing to pay for ESG, performance this year has broadly endured despite negative headlines suggesting its demise. FINANCIAL TIMES