Is a bubble forming in ESG investing?

RWC's Graham Clapp says the huge sum of capital flooding into ESG stocks is distorting share prices but does the industry agree?

Investors must not lose sight of ESG fundamentals amid a “tidal wave of inflows”, said RWC fund manager Graham Clapp, who warns ESG investing is in bubble territory.

Portfolio manager of the RWC Continental European Equity Fund has said investors who are flooding into ESG-oriented funds due to recent outperformance in the Covid-19 turmoil could be left disappointed.

“The E in ESG has a lot of momentum right now, and there’s a huge sum of capital going into companies seen as winners in this space”, he said.

“Many companies at the heart of this trade are loss-making, and keep warning on profits, yet shares keep rising. The situation may become more extreme from here, but investors should be aware that the more detached share prices become on the way up, as we are seeing now, then the more extreme the moves can be on the way down.”

Recently, Morningstar reported assets under management in global sustainable funds topped $1trn for the first time, as investment into more responsible funds gains momentum.

Higher exposure to healthcare and technology, and lower exposure to commodities and airlines, meant funds with higher ESG credentials tended to outperform during the extreme volatile markets in Q1 and Q2, as countries around the world were forced to go into lockdown to prevent the spread of the coronavirus.

See also: – Can ESG outperformance continue?

Although many commentators in ESG Clarity recently predicting this outperformance will continue as companies that are more environmentally and socially aware will drive the recovery, Clapp said there is a danger that many investors are losing sight of fundamentals.

While he said he supports ESG as playing an important role in risk analysis and identifying long-term opportunities, he is concerned ESG investing is “uniquely positioned to distort share prices” especially as pension funds increasingly embrace responsible investing in their portfolios.

“This ESG trend was already in place at the start of the year, but the tidal wave has continued throughout 2020,” he said.

“As with any bubble, these things are great on the way up, but the more we move away from fundamentals, the worse the outcome for investors is in the long-term.”

He added the “basics of finance” in companies such as wind turbine manufacturers, battery makers and hydrogen companies are being overlooked as investors want their piece of the “next big thing” and he is looking for opportunities elsewhere in Europe.

“We are finding the same degree of opportunity elsewhere, without needing to embrace the valuation excesses that are so apparent in ESG stocks right now,” Clapp added.

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Ben Yearsley, co-founder of UK wealth manager Fairview Investing, said over the short-term it could be argued that ESG investing is looking “bubbley”, but urged investors to consider the long-term.

“Over the short term, it does look like the technology sector [in a bubble] and there is a lot of hype around ESG,” he said.

“But over the long-term, ESG businesses tend to be quality growth businesses and I think they will will grow into those share prices.

“There is a difference between looking at this short-term and long-term, and I think over the long-term those share prices can be justified.

“ESG is being embedded into portfolios; it isn’t going away, it is here to stay.”

Although Ben Seager-Scott, head of multi-asset funds at Tilney, said he doesn’t think ESG is in a bubble, he does share some of Clapp’s concerns on the fundamentals of stocks.

“I think with any form of thematic investing, it is essential not to lose sight of the investing fundamentals, which means not just buying a theme because it’s hot and it’s doing well, but rather because you believe in the underlying investment case and that you are buying at a reasonable (or ideally cheap) valuation based on that investment case.

“Now, I do think that many ESG investments have had a natural tailwind which has helped them outperform over the last couple of years – they tend to avoid some of the worst hit areas such as mining, oil & gas, airlines and energy-intensive industrials, for example, as well as having less in many of the more cyclical parts of the market – but these benefits have general come with improving fundamentals, particularly during the Covid-19 crisis.

“I don’t think they are in bubble territory at all, and valuations certainly don’t look very stretched (as they would if they were in a bubble). Now it’s reasonably likely that some of the tailwinds will turn into headwinds when the cycle turns, but these are just temporary factors and I think ESG will remain a viable investment strategy for the long-term.”

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Natalie Kenway

Natalie is global head of ESG insight for ESG Clarity and has been an investment journalist for 16 years. She won Editor of the Year at the Aviva Investors Sustainability Media Awards 2021, and was Winner...