Do well by doing good? Don’t count on it.
Funds that invest using environmental, social, and governance, or ESG, criteria underperformed for a second consecutive year.
According to data from
Direct, sustainable U.S. equity funds were up an average 21.6%, including dividends, through Dec. 31, trailing the S&P 500 total returns index by about five percentage points. In 2022, the average sustainable U.S. equity fund was down 19.5%, against a loss of 18.1% for the index.
Morningstar uses the term sustainable funds to refer to mutual and exchange-traded funds focused on impact, sustainability, or ESG risk factors.
Zhihan Ma, global head of ESG research at Bernstein and author of the firm’s global ESG 2024 outlook, said two straight years of underperformance call for a renewed focus on generating returns in excess of the benchmark, or alpha, in investing parlance.
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The underperformance comes against a backdrop of pushback against ESG. In June,
BlackRock
’s
CEO Larry Fink said he no longer uses the term ESG because it has become “weaponized.”
And in the latest salvo, the state of Tennessee in December sued BlackRock alleging the world’s largest asset manager breached consumer protection laws by misusing ESG factors in its investment strategy.
Ma wrote that getting performance back on track is “mission critical for ESG investors, especially in the U.S. where the political environment has become less ESG-friendly.”
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In 2022, energy was the best-performing sector, spurred by a global spike in commodity prices following Russia’s invasion of Ukraine.
Most of the ESG underperformance in 2022 can be attributed to ESG funds’ underweight in the traditional energy sector, she noted in the report.
“When ESG funds underperformed in 2022, we blamed it on their energy underweight,” said Ma. “But a second consecutive year of underperformance in 2023 can no longer be easily brushed aside.”
In 2023, ESG funds were dragged down by too much exposure to clean tech and not enough to big tech.
The
Invesco WilderHill Clean Energy ETF
—a green-power benchmark—finished 2023 down 20% against a gain of 26%, including dividends, for the
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“On the one hand, ESG funds’ meaningful underweights in big tech names detracted from performance in a year of a concentrated tech-driven market rally,” she said. “On the other hand, ESG funds’ overweight in companies in the clean energy value chain also didn’t help, as these sectors came under inflationary pressure and faced fundamental challenges with weaker industrial demand.”
Last year, information technology and communication services were big winners. Sustainable funds often hold tech stocks because they score well on ESG ratings, which measure the impact of the world on a company’s bottom line, not the company on the world.
In an email, Ma told Barron’s it is a common misperception that ESG funds are overweight tech. “Big tech stocks are indeed major holdings by ESG funds on an absolute basis, but relative to benchmark weights, ESG funds have consistently underweighted big tech,” she said.
Ma analyzed the holdings of 2,727 ESG funds globally in the second quarter of 2023, and found that while ESG funds globally increased exposure to semiconductors, partly on the back of the AI-driven rally, North American ESG funds continued to underweight big tech names.
Apple
,
Alphabet
,
Amazon
,
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and
were some of the top underweights, which weighed heavily on performance.
“Let’s not forget that ESG investing is ultimately about investing,” she said in the report. “And return is king. We hope that the recent underperformance will serve as a wake-up call for the industry to refocus resources back on leveraging ESG insights to generate returns.”
Write to Lauren Foster at lauren.foster@barrons.com