ESG hiccup: Sustainable investment losses in 2022 highlight some market realities

INVESTMENTS labelled as sustainable or ESG (environment, social, governance) have suffered double-digit losses this year alongside the broader market, as a confluence of factors including higher interest rates and inflation cause a spike in risk aversion.

Two factors are blamed for the relatively poor showing: ESG funds’ exposure to technology which has suffered a rout, and their avoidance of fossil fuel stocks such as energy, which outperformed.

Morningstar’s US Sustainability Index has lost 21.66 per cent year to date, compared to 20.47 per cent by the S&P 500. The MSCI World ESG Index is in the red by 22.53 per cent compared to a loss of 21.91 per cent by the plain-vanilla MSCI World Index. ESG funds’ exposure to tech is relatively large at over 20 or 30 per cent because of tech’s relatively lower carbon footprint.

The recent underperformance underscores 2 factors: One, ESG sustainable funds’ historical outperformance was in hindsight largely fuelled by technology, which is now a drag on returns. Morningstar’s US Sustainability Index, for example, is 26 per cent invested in tech, led by Microsoft and Apple. Two, while an ESG approach is supposed to mitigate risk, it does little to shield investors in an environment like today’s where almost all assets are down at the same time.

Inflows into sustainable funds also slowed in the first quarter. Morningstar reported that US sustainable fund flows posted their fourth consecutive decline as inflows fell to US$10.6 billion, less than half of the all-time flows record of nearly $22 billion a year ago in the first quarter of 2021.

Still, the sustainable assets fell less than the overall US market, says Morningstar. In the first quarter of 2022, assets in sustainable funds fell by 4 per cent, but assets in the overall US market fell by 6 per cent.

Over the past couple of years, the argument for an allocation into sustainable funds has been burnished by a relatively strong performance record, convincing investors that they can do well as they do good. It remains to be seen whether interest among retail investors will flag. After all, 6 months is a very short period in the overall scheme of things, and the climate emergency shows no sign of abating. In fact, global action towards a net-zero world may well take a back seat. Financing the transition is now more challenging as governments grapple with higher inflation and markedly slower growth.

Among institutions, interest remains keen. A 2022 survey of institutional investors by the Capital Group found an increasing momentum in ESG adoption, fuelled by client demand and external pressures. Europe leads the charge in adoption, while the North American region has the lowest conviction.

As a retail investor, navigating sustainable fund choices remains confusing. Here are a few aspects to consider:

Greenwashing less of an issue?

In an article on ESG trends in 2022, MSCI says the risk of greenwashing is receding, particularly as a common ESG language emerges. It says for retail investors, standards are “solidifying rapidly”, helped largely by the EU’s Sustainable Finance Disclosure Regulation (SFDR), which has improved disclosure and labelling of Europe’s ESG funds. MSCI cites an example: Its Implied Temperature Rise indicator finds that funds categorised SFDR Article 8 and 9 were more aligned with a 1.5- to 2-degree global warming trajectory vs uncategorised funds. The funds were also on the lower end of carbon intensity.

Industry participants are also doing their part to weed out funds whose stated documentation may not be borne out in the investment process. Morningstar earlier this year removed the ESG tag from more than 1,600 European funds, representing US$1.2 trillion in assets, following a review of fund documentation when SFDR took effect. Prior to the SFDR, Europe’s fund industry voluntarily removed the ESG tag from around US$2 trillion of funds.

Under SFDR, Article 8 funds are “light green”; they promote environmental and/or social characteristics. Article 9 funds are “dark green”; they have sustainable investment or a reduction in carbon emissions as the objective. Most funds marketed in Singapore are European domiciled, and must comply with the SFDR. Still, it is challenge to discern whether a fund is being invested in line with stated objectives.

Fossil fuels: Avoidance, divestment or engagement?

Negative/exclusionary screening is the most common approach to sustainable investing, according to the Global Sustainable Investment Alliance. ESG funds may exclude coal, nuclear energy and palm oil production.

In the transition towards net zero, however, fossil fuels are still needed in the absence of alternative energy sources at scale.  Divestment may be shortsighted as it pushes producers towards less transparent sources of capital, further squeezes supply and raises prices that poorer countries can ill afford.

BlackRock’s chairman Larry Fink has argued that helping clients navigate the energy transition involves working with hydrocarbon companies “to ensure the continuity of affordable energy prices during the transition’’.

In its paper on ESG trends, MSCI suggests that investors could take a mixed approach, “deftly’’ using both divestment and engagement – “plus assert a greater voice in climate policy discussions’’. 

Engagement: How effective is your manager?

The process of engagement has been likened to a proverbial black box, with reason. This is because the process may be long, and the fund manager may not disclose specific progress.

But your manager is likely to publish an annual or 6-monthly sustainability and/or stewardship report to tell you where the firm’s priorities lie. You could also examine your manager’s record of voting on proposals relating to governance, climate change and social issues like diversity.

Ceres’ 2021 report notes a “dramatic increase’’ in votes in support of climate-related proposals, particularly among the largest asset managers. On average, asset managers voted in favour of 63 per cent of the climate related shareholder proposals in 2021. The 2 largest asset managers, BlackRock and Vanguard, dramatically increased their votes in favour. This helped to propel the average vote on climate-related proposals to 41 per cent from 31 per cent in 2020. 

Ceres notes the use of shareholder resolutions as part of institutions’ engagement strategy with the world’s largest greenhouse gas emitters. “A long overdue development, it nonetheless shows asset managers are finally diverging from company managers, who frequently recommend votes against these climate proposals …’’

Net-zero asset managers initiative: Work in progress

NZAMI is an initiative to support net-zero emissions by 2050. To date it has 273 signatories representing over US$61 trillion in assets. Within 12 months of signing on, asset managers have to disclose the proportion of assets to be managed in line with net zero, and the assets’ emission reduction targets by 2030.

Morningstar has published a report on the NZAMI’s second progress update. It found that the net-zero commitment by 43 managers, who were named in the first update, ranged between 4 and 100 per cent. Only 9 managers committed 100 per cent of their AUM, and 15 committed less than 50 per cent. The “Big Three’’ managers – BlackRock, State Street and Vanguard – show wide disparity in their commitments at 77, 14 and 4 per cent respectively.

It’s important to note that the variation in commitment partly reflects the methodology – for example, whether sovereign assets are included or not. Some managers excluded sovereign assets because of the lack of an accepted methodology for net-zero targets. Some also excluded mandates requiring client approval. BlackRock included sovereign assets on the expectation that governments will follow through as signatories of the Paris Agreement.

NZAMI has said that all managers are expected to commit 100 per cent of their AUM in the next 28 years.