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How to pick a green winner

There is compelling evidence that environmental, social and governance funds can outperform their less sustainable counterparts, but what’s driving superior returns?

Huge flows into environmental, social and governance (ESG) funds have pushed their prices up this year, making future returns harder to sniff out. But many believe the ESG market is not yet a bubble and there will be more good returns available if you look carefully.

ESG funds’ popularity has rocketed, with some statistics showing funds under management exploding by 1,000 per cent in the last 12 months. This follows increasingly compelling evidence that ESG funds outperform non-ESG funds over the short and long term. A recent study from Morningstar showed most sustainable strategies outperforming non-ESG funds over one, three, five and ten years.

But research explaining that outperformance, which is essential for picking future winners, is harder to find. ESG funds’ good returns may be due to direct ESG factors, other indirect causes or even chance. And even if we can identify causes of performance, it is hard to know whether they will repeat in future.

Does ESG improve performance?

ESG fund managers have jumped on evidence of outperformance, touting their approach as a “vaccine” against stock price falls in a crisis.

But simply investing in ESG is no guarantee of success. Morningstar data shows the best performing ESG fund this year (Baillie Gifford Positive Change) has returned 55.5 per cent so far, but the worst (Schroder Responsible Value UK Equity) lost 32.9 per cent.

A study by New York University suggests, contrary to fund managers’ claims, that sustainable stocks do not perform better in times of crisis. Instead, innovation and good liquidity are more likely to make a stock financially resilient.

But others believe ESG factors can drive outperformance. For example, research from Amundi Asset Management shows that, for European portfolios, governance is particularly important in determining outperformance. For North American portfolios, environmental factors are most significant.

Other studies suggest these drivers could also strengthen in future because ESG funds are becoming more targeted on “material” sustainability issues that impact a firm’s valuation. For example, carbon emissions are material for an energy company, but not for a financial services group.

Sustainable investing isn’t a bubble yet

Most specialist ESG financial advisers say it will continue to offer good returns. Richard Skerritt, managing director at Skerritts Wealth Management, says: “It is not a bubble. It is at the start of a long run, with more companies embracing ESG principles and more good stocks becoming available. The types of company ESG funds invest in, for example those promoting remote telecommunications to reduce travel, are here to stay.”

Sophie Kennedy, head of investment at EQ Investors, says: “We see ESG’s outperformance as long term and expect these companies to further benefit from recovery packages around the world, such as the European Union Recovery Fund. A third of that funding is earmarked for digitalisation and cutting carbon, so ESG businesses should be in pole position.”

Philip Wise, retirement income planning director at Informed Choice, says: “Drivers such as UK changes to pension scheme rules that favour strong ESG companies have only just started to have an effect. Europe is focusing on a green recovery and incoming US president Joe Biden has a green outlook. So there will be more money available for ESG projects.”

Picking sectors and investment strategies

Sector allocations could play a key role in picking future winners. ESG funds have generally performed well this year because the sectors they tend to avoid, such as oil, have suffered during the pandemic. But those they prefer, such as healthcare and technology, have fared well.

These trends look set to continue. So picking a fund that does not constrain itself to sector allocations, but can adjust them according to the manager’s conviction could be advantageous.

Future outperformers will have ESG embedded into their processes, not outsourced

A stronger ESG process should also help. “In the past, people thought the greener your fund, the more you compromise performance,” says Skerritt. “Now, we believe the opposite: the better the fund’s ESG credentials, the better its prospects.”

Wise says that in good ESG funds, additional scrutiny and focus on profit sustainability will make a difference to performance. “Future outperformers will have ESG embedded into their processes, not outsourced,” he says.

Selecting long-term ESG performers

Lee Coates, director at Ethical Investors, recommends using actively managed funds rather than index trackers to find future ESG returns. “Data can help drive performance, because good managers can look for valuable information about climate change and corporate activity,” he says. “Passive funds cannot assess that and predict change, they can only follow.”

Kennedy says picking winners will require lots of research, especially if you want to make sure the funds also match your ethical values.

“Plenty of funds and portfolios are labelled sustainable or ESG, but on closer inspection are nothing of the sort,” she says. “Check the holdings match your values and that the fund has a dual mandate: to deliver long-term returns and positive change.”

There is evidence showing that cheaper, passive index trackers can succeed in this sector as well, for example 73 per cent of Morningstar’s ESG indices have outperformed their non-ESG equivalents since inception. Given the huge range of good and bad-performing active managers, passive could be the safest option. But it would also mean giving up some of the positive returns an active manager might continue to get from this sector.

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