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We need to talk about ESG outperformance

This week, the SEC set its sights on greenwashing; sustainable bond funds hit new highs; the debate deepened between active and passive. Plus, what will we learn from ESG's asset allocation problem?

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🔬 The SEC turns to the question we've all been asking: how do you separate real sustainable funds from the fakes? The US regulator recently found issues with so-called ESG ETFs. (Spoiler alert: we're soon putting US funds to the test.)

📊 Last week, we argued for data instead of disclosures. Before that, we looked at the ways companies game investors and ratings. Schroders' Andy Howard appears to be on the same page, warning that third-party ratings amount to "a fool's errand".

💣 ESG is still in vogue despite a "data minefield." But in the absence of standards and frameworks, and with company disclosures increasingly distrusted, many investors must rely on a traditional, but limited, approach: hands-on engagement.

⚖️ Does that mean active beats passive in the world of sustainability? Negative screening has been outsold by positive screening and thematic funds, reports the FT, as limited data remains a challenge for index funds. We say: watch this space.

🛁 Sustainable portfolios have an asset allocation problem. In the last year, they benefited from alpha, magnified by narrow concentration. But when performance reverts to the mean, investors risk losses from unbalanced allocations.

📈 Morningstar data show flows into sustainable bond funds are on track to surpass last year's record, despite growing greenwashing concerns. Investors have piled in $54bn, but challenges remain: “ESG is easier in equities, and one reason is data.”

❓ A lack of understanding about impact investing among retail intermediaries, their clients, and institutional investors is harming take-up of impact investment funds, according to the recent Research in Finance UK Responsible Investing Survey

📣 "ESG means different things to everybody. I show risk reduction and value preference as a Venn diagram. The more we reflect either, the smaller our universe." Morningstar's Dan Kemp issues a warning on portfolio construction.

🌪️ The 11th EY/IIF bank risk management survey finds—for the first time—banks consider climate the biggest risk to business, thanks to extreme weather, climate stress tests, stranded assets and transition risks. But they also see opportunity.

We need to talk about asset allocation

In the next decade and beyond, tackling social and environmental problems will increasingly inform the world's investment decisions. Morningstar data show 50% of European passive funds are likely to be branded ESG by 2025. PwC suggests all money will be managed with a sustainability lens by then. Increasingly, there's an imperative for companies to appeal to ethically-conscious investors and consumers to stay on the radar.

That's great news. But don't expect it to guarantee outperformance.

Sustainable investing took off last year, as mounting environmental concerns dovetailed with pandemic-induced anxiety around social issues. A dizzying, record amount of capital poured into ESG funds—which outperformed their parent indices.

Cheering outperformance sets a dangerous precedent. People have said as much, quietly, in the last year; over the last week, those murmers have got louder. If sustainable investing is about capturing alpha, then what happens if—or when—the performance of ESG-friendly sectors reverts to the mean?

Writing in Investors Chronicle, Julian Hofman argues outperformance comes down to asset allocation: namely into growth, particularly tech, stocks. "During the ethical investment boom of the past year-and-a-half, investors have fuelled an existing bias towards technology stocks – Facebook, Apple, Amazon, Netflix, and Google-owner Alphabet, along with maverick companies such as Tesla – and avoided the big fossil-fuel industries that also happened to suffer from lack of demand during the pandemic," he observes. His sentiments are echoed by ETF Stream's Jamie Gordon, who writes that "ESG funds’ outperformance in 2020 was lucky: the sector is tilted towards tech and healthcare monopolies and avoids the employee-intensive firms which suffered the most from the pandemic.”

So, why are investors re-evaluating the narrative now?

This year, large-cap-growth-overweight strategies have started to underperform. That may not be temporary. Growth stocks, such as the FAANGs and Tesla, have been fuelled by central bank liquidity. If that liquidity continues to run, so will growth. But with inflation on the rise and central banks likely to raise rates, a question mark hangs over this bull market's favourite play.

For today's sustainable strategies, past returns are no guarantee of future performance. And losses may be magnified by the very same force magnifying recent gains: an unusually high level of alpha was exacerbated by a narrow concentration of assets. "As soon as performance reverts to the mean, many ESG investors risk sitting on big losses generated by a portfolio that has such an unbalanced allocation," Hofman points out.

As Hofman, Gordon and others conclude, this won't derail the trend towards sustainability. Finance has a critical and unavoidable role to play in solving the world's greatest challenges. But it does present an opportunity to reflect on what the future of sustainable investing looks like—and what can be done better.

There are three ways in which current approaches are too simplistic.

At present, portfolios tilt towards large-cap companies, which have more resources to disclose. Big firms benefit from economies of scale. This is evident in index composition, with the average market cap in an ESG ETF 20% larger than in the traditional Russell 3,000 index.

Yielding to appetite for climate-friendly investments, most play to the 'green' theme—often superficially or without nuance. The world's a complicated place. Nowhere is the law of unintended consequences more evident than in sustainable investing. Take, for instance, the urgent demand renewables are placing on mining.

Finally, there's the problem of asset allocation.

Sustainable investing does not exist solely to generate above-market returns, but there are ways to build better portfolios. Capturing companies of all sizes, addressing the full value chain of any sustainability theme, and diversifying company and sector exposure are three good places to start.

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