More nuance is needed when looking at the performance of ESG funds to avoid the whole field being unnecessarily dragged down by the lowest common denominator, according to Barclays.
Damian Payiatakis, head of sustainable and impact investing at Barclays Private Bank, said the world of sustainable investing is due to become more turbulent in the second half of the year as teething problems, such as how to look at performance, are worked out.
For example, the fact the ESG universe includes all-industry funds right through to highly thematic sector-focused funds. If one of the sub-groups of ESG funds performs badly it could reflect on the whole field.
Also, Payiatakis said, a high score on ESG ratings does not necessarily mean a company is of a high quality or that it will be financially successful.
“ESG ratings provide an algorithmic judgement based on backwards-looking, available and generally self-reported data on how well a company manages its material ESG risks,” he said.
He added there is a chance ESG investors will overlook other factors that could pose a financial risk such as industry dynamics, effective strategy and execution and where an investment sits from a market cycle perspective.
See also: – Don’t be put off by short-term underperformance in ESG
Other areas Payiatakis flagged were the risk of an ESG bubble where a change in market conditions could drag ESG stocks down.
Finally, he noted the increasing risk of greenwashing as investors struggle to navigate sustainable marketing.
Here for good
Despite the warnings, Payiatakis believes ESG investing is here to stay and predicts flows will accelerate even more in the coming months as governments increasingly embrace sustainability and regulators try to ensure it forms part of the investment process.
Payiatakis recommended: “In the short term, investors can understand and prepare for risks driven by likely structural changes and the impending market conditions.
“For example, analysis of current governmental policies and plans demonstrate we are not on track to meet Paris Agreements of two degrees centigrade, let alone the 1.5 degrees ambition. Governments will have to respond.
“Therefore, investors might review portfolios for the transition risks and carbon intensity in advance of this inevitable policy risk.
“Separately… investors face the risk of rising inflation and need to reassess investments, and entry points, accordingly.”
Payiatakis said where investors are looking at specific sustainable themes and sectors – renewables and electric vehicles, for example – they should be aware much of their valuation is driven by potential growth.
“In an inflationary environment with higher discount rates and with market rotation, these sectors may fall from favour. This may require patience from investors during a downturn. Or it may provide a more attractive entry point for those who missed an earlier opportunity and find the potential volatility acceptable,” he said.