A new trend among some of the nation’s most established mutual fund companies illustrates just how white-hot the ESG investing market has become in recent years. But some question whether these funds are ESG in name only, raising concerns of greenwashing.
American Century Investments, Putnam Investments and USAA are among the firms rebranding some of their stalled funds as strategies that offer exposure to investments that support environmental, social and governance criteria.
At least 61 funds from 37 companies have been converted to ESG strategies since the start of 2018, and the total number of ESG funds has grown over that period by 63% to 439 through the first half of 2021, according to Morningstar data.
The trend is raising eyebrows among those who wonder whether the firms are just jumping on the ESG bandwagon.
“It is hot money for sure and every asset manager is scrambling to catch up,” said Aaron Brachman, managing director at Steward Partners. “Everyone wants to be in the ESG space for the AUM growth, but there are pretenders and there are contenders.”
Brachman stresses the importance of thorough due diligence and fully understanding what you’re buying.
“When we’re investing for clients, we don’t look at whether it says ESG or not, because we have our own ESG screening process,” he said. “Everyone has great marketing literature, and it all looks great, usually showing a bunch of trees, but you have to look under the hood.”
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Seven of the conversions include American Century Fundamental Equity becoming American Century Sustainable Equity, USAA World Growth becoming USAA Sustainable World, Putnam Multi-Cap Growth becoming Putnam Sustainable Leaders, Invesco Floating Rate becoming Invesco Floating Rate ESG, and Nuveen Winslow Large-Cap Growth becoming Nuveen Winslow Large-Cap Growth ESG.
MEETING THE DEMAND
Morningstar analyst Jon Hale gives fund companies credit for moving in the direction of demand. ESG funds had more than $39 billion worth of net inflows this year through the end of June. That compares to $51.1 billion for all of 2020, $21.4 billion in 2019, and $5.5 billion in 2018, according to the research and data firm.
“A lot of fund companies have inventory on their shelves of active funds that have been net flow negative for a number of years,” Hale said. “Over time, once a fund ages, those assets start to roll off. You have to continually bring in new money, and active funds can’t really do that anymore. In a number of cases, the decision has been made to turn some of those funds into ESG funds, and I think that’s largely what’s happening there.”
The net asset flows into ESG strategies make a compelling case for jumping on the bandwagon.
“It definitely helps to be ESG-compliant,” said Neeraj Mahajan, an analyst at Anchor Capital Advisors, a $10 billion asset manager that formalized its ESG focus two years ago.
“Absolutely, money is flowing in because of our ESG focus,” he added.
But Mahajan also acknowledged that ESG strategies are riding a wave of outperformance that is at least partially attributable to a correlation with growth stocks and sectors.
“ESG factors have been a tailwind the past couple of years,” he said.
Random snapshots over the past few years produce ample examples of ESG tailwinds driving funds to remarkable performances.
Last year, Invesco Solar ETF (TAN) gained 234%, FirstTrust Nasdaq Clean Energy ETF (QCLN) gained 184%, and iShares Global Clean Energy ETF (ICLN) gained 141%. That compares to a 16.3% gain by the S&P 500 Index over the same period.
Meanwhile, none of those three high-performing funds even made it into the top 10 through the first eight months of 2021, when the top funds gained between 25.8% and 28.7%, and the S&P gained 21.6%. Over that same period, TAN was down 18.9%, QCLN was down 7.1%, and ICLN was down 19.6%.
The annualized returns of the 10 best-performing ESG funds from the start of 2018 through August 2021 ranged between 38.4% and 58.7%, compared to 18.1% for the S&P 500, illustrating the recent outperformance of the category.
A QUESTION OF DURABILITY
The recent strong run for ESG, however, has some questioning the category’s ability to keep it up going forward.
One academic study by professors from the University of Chicago Booth School of Business and the Wharton School of the University of Pennsylvania, titled “Dissecting Green Returns,” applies economic logic to suggest the ESG rally has been driven primarily by negative environmental news.
“The last several years were special years in an unexpected way,” said Lucian Taylor, Wharton finance professor, and one of the authors of the report. “When people become more concerned about climate change, that makes green stocks outperform.”
Taylor said ESG investors should not expect that strong recent performance to continue. According to the research, the only way ESG stocks can continue to outperform would be as a result of a steady stream of progressively more negative environmental news.
ADVISERS WEIGH IN
The financial adviser community — an important avenue the asset management industry relies on for distribution — still includes critics, skeptics and holdouts when it comes to investing using ESG criteria.
Andy Martin, president and founder of 7Twelve Advisors, has a mostly blanket resistance to what he believes is an industrywide effort to force ESG upon the masses.
“It’s not ESG, per se, that I’m not a fan of; it’s the intent of the regulators and the measuring firms to run everyone through ESG screens,” he said. “I don’t care if you have a tattoo, just don’t make me get one.”
Martin is not fully convinced of the economic value of ESG compliance when spread across companies, funds or investment portfolios.
“It’s a wonderful hobby but a horrible replacement for finance,” he said. “If you wish to have an ESG fund, go for it. There’s tremendous value for those investors. It’s a growing world. I’m not trying to stand in front of it. But when I get asked how I comply to ESG metrics and can’t update my records without proof of ESG compliance, that’s absurd.”
Scott Bishop, executive director at Avidian Wealth Solutions, is also in the camp that ESG is driven more by marketing than finance.
“I am not focusing on any mutual funds that invest primarily in ESG,” he said. “I think it is more marketing than reality for those wanting to truly have an impact on the environment.”
To Bishop, the rebranding trend is more evidence that the strategies can sometimes be less than pure.
“If I found a fund or a private deal that truly was investing in and truly trying to have an impact in environmental causes and social fixes, then I may be interested,” he said. “Just picking publicly traded companies with a good ESG rating is something I am not interested in.”
Mackenzie Richards, a financial planner at SK Wealth Management, said it’s disconcerting but not surprising to see asset management firms moving into this most fashionable space. “I expect that the influx of cash many of these pseudo ESG funds are seeing will be temporary as ESG rankings continue to become more transparent and widespread,” Richards said.
Sean Meighan, managing director in advisory services at Atria Wealth Solutions, is seeing “varying degrees of ESG adoption at the adviser level.”
He separated advisers into three broad groups: “Some advisers could care less, some are reactionary and starting down the path, and a few advisers are full bore making ESG their entire business.”
“The middle group is the gateway into ESG investing, assuming they have the tools,” Meighan said.
Whatever the forces, and despite resistance, the momentum is real.
Brett Wayman, senior director of impact investing at Envestnet, agrees that looking under the hood is essential when it comes to ESG investing, but he doesn’t buy into the criticism about ESG metrics being non-financial or that ESG funds’ performance is peaking.
“Value and risk are created in the real world, not in the capital markets, and that’s what ESG is trying to identify,” he said. “It’s about looking at which companies are adapting to intangible risks in the real world that are not found on the balance sheet.”
Wayman understands the reluctance of advisers to jump headlong into the ESG space, but he also believes it is a mistake to ignore it.
“Advisers are faced with an immense need to know about everything going on in the industry, and that’s overwhelming, and once you throw in ESG, which is not codified, it’s like the Wild West because we’re still developing all the nuances around it,” he said. “But ESG will be table stakes in the next three to five years, and every asset manager will have a process.”