Outflow from S-E Asia ESG funds continues on higher energy prices

CAPITAL continued to flow out of environmental, social and governance (ESG) funds in South-east Asia, and into non-ESG funds, for a second consecutive quarter on the back of higher energy prices.

ESG funds domiciled in Singapore, Thailand, Malaysia and Indonesia recorded net outflows of US$66.2 million for the second quarter of this year, according to data from Morningstar. That extended an outflow of US$104.1 million in the previous quarter, and reversed net inflows of US$37.6 million from a year ago.

Conversely, non-ESG funds in the four Asean markets saw net inflows of US$6.8 billion, adding on to US$3.4 billion of inflows in the previous quarter. In the same period a year ago, non-ESG funds recorded outflows of US$5.6 billion.

However, while ESG funds record capital outflows, they had better average returns than their non-ESG counterparts.

ESG funds’ average three-month returns for Q2 came in at -1.3 per cent, an improvement from -15.6 per cent in the same period a year ago.

They outperformed non-ESG funds, which achieved an average quarterly return of -2.9 per cent, though this was better than an average return of -11 per cent a year ago.

Analysts have attributed the outflows seen in ESG funds to higher energy prices, a challenge largely arising out of the Russia-Ukraine conflict.

In addition, tight supply due to multiple periods of underinvestment and production cuts by the Organization of the Petroleum Exporting Countries – a collective of oil-producing countries – have exacerbated the problem.

“This could have led to some continued rebalancing of investments towards energy and similar sectors where investors have been underweight for some time,” said Christopher Wong, client portfolio strategist for South-east Asia at Fidelity.

Continued elevated inflation and concerns over more interest rate hikes could also be a contributing factor, Wong said. This is because ESG funds tend to have larger exposure to growth stocks in technology and other faster-growing sectors, which can be more sensitive to rising interest rates.

“As interest rate expectations have continually shifted through the course of 2023, that could also have created a dampener to interest in these areas,” he said.

In addition, investor sentiment towards ESG funds could be more cautious, as they have been anticipating a potential recession in developed markets for some time, especially towards asset classes such as equities where many ESG funds tend to invest in, said Wong.

Thomas Hohne-Sparborth, head of sustainability research at Lombard Odier, said that investors may be starting to more selective in their assessments of ESG funds, as they turn towards funds that deliver value both from a sustainability and financial perspective.

This is a result of the market maturing and recognising that not all ESG funds are created the same, he added.

The conventional approach to ESG investing has been centred on measuring a company’s performance through indicators such as its policies or carbon footprint.

However, Hohne-Sparborth said that such an approach only “provides a very partial insight into the overall positioning, relevance and financial exposure of these companies to much broader system changes”.

As sectors transition and decarbonise, there would be structural shifts towards alternatives that are decentralised, electrified, biobased and resource-efficient.

“This involves profound shifts in value chains, addressable markets, and profit pools. For investors, this requires us to consider not merely whether one cement company is better than another (the traditional ESG approach) but rather whether profit pools might shift in a more profound manner, for instance from cement to alternative solutions (such as timber),” said Hohne-Sparborth.

Hence, while capital flows are currently moving out of ESG funds and into non-ESG funds, this is just for the near term, he added, and it does not change the “inevitability and momentum of the underlying energy transition that continues to accelerate”.

“We are now seeing uptake of renewables, electric vehicles, and other electrified, non-fossil technologies accelerating in key markets, with Asian markets leading in quite a number of these.”

Indeed, the better returns from ESG funds, despite the outflows, could be indicative of this structural shift.

New emerging business models that are aligned to sustainability lead to a more resource-productive economy that may involve an upfront capital expenditure outlay, but substantially reducing operating expenditure, said Hohne-Sparborth.

One example is how new manufacturing processes, such as additive manufacturing, require fewer materials.

“This dynamic is at the heart of the superior economics that we identify for many of these breakthrough technologies, products and services that environmentally-aligned funds generally have a higher exposure to,” Hohne-Sparborth added.

“In other words, we have a strong investment conviction that this transition is driven by superior economics, and not only superior ESG characteristics. There is, hence, a strong fundamental basis to expect funds with exposure to these themes to be able to generate returns for investors.”

The better returns from ESG funds, despite its outflows, reflect how the environmental and social impact objectives of some of these funds are supported by clear, multi-period structural trends – such as the transition towards clean energy, which can potentially support long-term earnings and share price growth, said Wong.

In addition, ESG funds tend to have a higher allocation to quality companies that have better ESG credentials.

“This can lead to better overall investment returns over the long term, especially in volatile markets, where markets tend to seek out higher quality companies,” said Wong.

In the near term, ESG funds could potentially do well as technology stocks, which tend to feature heavily in such funds, have started performing better than broader markets this year, said Wong.

And this could extend over the medium-to-long term as recession fears recede and inflation continues to come under control, which could signal the end of the aggressive global interest rate hiking cycle. Stronger returns could then subsequently be a catalyst for ESG fund flows.

On a longer-term basis, Wong said that there remains a clear trend towards ESG funds as many investors are increasingly aware of the risks to returns from not integrating ESG factors into investment processes.