Pandemic sparked a rotation of sector leadership that helped ESG funds soar

ESG fund investors should be aware of cyclical trends.

With all the attention being given to ESG funds over the past several years there has always been the long-running axiom that ESG funds underperform conventional funds, writes Bob Jenkins, global head of Lipper Research, Refinitiv, for ESG Clarity US.

For many of the formative years of these types of funds, there was some truth to this that had much to do with how early ESG/SRI funds were designed. 

A chief characteristic was the use of negative screening, or simply avoiding stocks and industries altogether that seemed out of line with the funds investment objective.  This often meant taking a pass on all things energy as well as the dreaded “sin” stocks and sticking instead to less nefarious names in consumer discretionary and staples as well as some easy-to-justify financials and the occasional tech stock. 

What this meant was that these early ESG/SRI funds were missing out on some very profitable companies with strong, steady cash flows, profits and dividends. It also meant less sector and industry diversification, which inevitably led to choppier returns and significant cyclicality. So, yes, many of them didn’t perform particularly well.

A funny thing happened on the way to ESG funds becoming the hottest trend in finance though. New products were proliferating, and many tended to lean toward the high-flying tech and internet stocks that have been ascending, practically non-stop, for the better part of the last decade. It was an easy decision really. Most of these fund shops were already investing in these stocks in their conventional, non-ESG fund lineups, so they were familiar with them. And most of these tech companies had negligible environmental footprints, so they all seemed to fit the bill nicely. 

Then, next thing you know, ESG funds, as a group, started to show outperformance. Quite coincidentally, over this same time period, major shifts were taking place in energy-related sectors such as the breakdown in oil prices and changes in demand, that led to generally poorer market returns for energy and carbon intensive companies. 

So being an ESG fund that was generally shunning these stocks while loading up on the internet darlings, meant robust returns to shareholders. The long-running myth around ESG fund outperformance seemed to have been vanquished.

Then along came the pandemic. At first this played brilliantly into the hands of these retrofitted ESG funds, as the stay-at-home stocks that shot through the roof last spring and summer were largely the same technology and internet companies that these ESG funds were already heavily positioned in. At the same time, oil actually printed a negative spot price as energy stocks plummeted.

As can be seen in the chart below  — which represents the one-year period through March 2021 encompassing the pandemic sell-off and rebound  — ESG funds did well in outperforming their benchmarks. 

And then the music slowed a little bit.

As the benefit of vaccines began to course through the system, so did the markets’ interest in the reopening trade. This meant that those shunned industries that had fallen so hard in the spring of 2020 — such as energy, industrials and materials — were now roaring back to life. 

At the same time, interest rates started climbing out of a very deep hole and putting pressure on the highly valued tech and internet stocks. The result was a classic sector rotation that started putting the long-trailing value stocks back in the driver’s seat while the overweight growth and momentum stocks started to waffle and trail off. 

As of this writing, energy stocks are still the leading sector for performance in 2021 by a factor of two over tech stocks. The rotation to value really started in Q4 and it slowly built momentum and ate away at all the initial gains the growth names had achieved in the pandemic rebound.  By early spring of 2021 they caught up entirely and began outpacing their Growth peers into the early summer. 

The chart below — while only three months different then the preceding chart — shows this remarkable turnaround and how it was, essentially, a double whammy on ESG fund performance.  Their over-weighted tech and internet stocks flat-lined while the scantly existent holdings they had in value stocks were thriving. 

Frankly, all funds — ESG or not — have been overweight these same tech stocks for some time. Conventional managers didn’t fare well either, but the ESG managers have been seeing some particularly poor performance of late.

As we ease into late summer, this rotation has also eased back a bit and, in fact, the market right now is enjoying the benefits of both growth and value doing well on the year, so the pronounced performance differences will also likely settle out. 

The takeaway here is to know what your funds are invested in — and not invested in — so that you don’t find yourself surprised when cycles occur.  It may also be worth considering ESG funds that employ a strategy of seeking broad sector diversification by investing in ESG leaders in some of the more sensitive industries, like energy firms, that are innovating and taking leadership in their carbon transition journeys.  This can help smooth the bumps while also putting your money into companies promoting good ESG outcomes.