Should we be worried about environmental funds?

Clean energy has been painful for investors recently but a strong structural backdrop and cheaper valuations might entice them back

As I sit here in London in mid-September during a heat wave after the hottest July and June on record and watch with horror the impact of wildfires around the world, it’s hard to reconcile with a narrative that tackling climate change has become less of an urgent priority.

But we are most definitely not where we were at the time of COP26 in Glasgow a few years ago with regard to sentiment around environmental investing. While the environmental problems have not gone away, some of the optimism around investing in the solutions has waned.

This has coincided with a political backdrop where there is increasing pushback against environmental policies. Examples of this in the UK have been seen recently around the proposed expansion of Ultra Low Emission Zones in London. Without adding to the deluge of commentary on the merits of schemes like this, what it does highlight is a degree of public scepticism around whether environmental policies are deemed to be financially detrimental during a cost-of-living crisis.

This has taken place during a period of generally poor relative performance for environmental funds when compared with broader markets. Take the energy sector – for example, the iShares global Clean Energy ETF is down over 35% over the past year, with the not so clean energy Vanguard Energy ETF in positive territory. While the latter has nearly tripled over the past three years, the former has underperformed cash.

Clean energy generation has been painful

But it isn’t that straightforward. Funds focused around clean energy generation have fared particularly badly over the past year or so, largely due to their exposure to the US utilities sector. The MSCI World Utilities sector is down around 15% over the past year, but there has been a big divergence regionally here. While European utilities are mildly positive over this period, US utilities are down over 20%.

While there are varying approaches to energy taken by environmental funds, strategies focused on clean energy tend to have significant exposure here, precisely because of the better legislative backdrop in the US. The iShares global clean energy ETF has around half the fund in utilities. This sector traditionally does badly in times of rising inflation and interest rates.

Clean energy utilities have also had to contend with challenging supply chain issues around areas like solar and wind equipment. Perhaps more simply clean energy generation was an area where share prices were overvalued. The iShares global clean energy is up more than 90% over the past five years, despite the aforementioned terrible three-year period it has just endured. Most of these returns took place between March 2020 and January 2021. Arguably something had to give. And it has.

But demand has been strong

Funds focused on the demand side of the clean energy equation have fared better and this makes sense. The past three years have seen the US economy power strongly out of the Covid pandemic and sales of electric vehicles have been robust. While a relatively low proportion of new cars sold globally are electric, this is changing.

Batteries have become cheaper and more powerful with consumers in many parts of the world less challenged by ‘range anxiety’. The L&G Battery Value Chain ETF, for example, is up around 70% over the past three years and this area coped relatively well during both the 2022 market sell off and 2023 period of relatively narrow stock leadership.

Some of this comes down to sector exposure. The combination of industrials and technology, and relatively diverse regional exposure split between the US, Europe and Japan has created a robust investment theme. Active environmental managers often tread carefully around stocks like Tesla due to concerns around corporate governance and the CEO’s use of social media, so are often underweight the best performing stock in the electric vehicle universe.

Other environmental themes have also been resilient

Most environmental policy and investment discussions tend to be dominated by decarbonisation. But it should be pointed out environmental challenges go beyond reaching net zero. Arguably providing safe, clean and plentiful water to the world is an equally big environmental challenge. Huge water shortage and sanitation issues have emerged in many places in the world. The L&G Clean Water ETF illustrates this point and is up around 40% over the past three years and was particularly resilient during 2022.

Another good example is our continuing refusal to stop buying things and throwing them away. Problems like plastic pollution are becoming increasingly acute and getting more publicity as we see the visual impact of these on beaches. The waste management sector which looks at solutions in this space has also been resilient over the past few years.

Environmental funds don’t own big tech and dirty energy

When comparing environmental funds to traditional markets it’s worth remembering what they haven’t been invested in. ESG funds – for obvious reasons – tend not to invest in big tech or dirty energy stocks.

But, the past three years have been characterised by two main market narratives: inflation and AI.

The first was a period between late 2020 to early 2023 characterised by inflation and the only equity sector to really perform well was energy. Environmental funds that avoided energy stocks missed out on the strong performance of many energy producers in 2022. Just to put some numbers around this, the S&P 500 energy sector was up c50% in 2022. The wider S&P 500 fell c 20% over the same period. 

The second was huge hope around the potential for AI to change the world and this so far has been expressed in the share price of a relatively narrow group of companies. Just to put this into context two-thirds of the return of the S&P 500 in 2023 so far has been delivered by the ‘magnificent seven’ AI stocks. Fund managers really needed one of big energy or big tech to compete favourably with the MSCI World over the past three years, and most environmental funds – understandably – have had relatively limited exposure to these areas.

While some of the political and media commentary around environmental investing has become more negative, the need for solutions to environmental challenges has not gone away. The world is going to shift to cleaner sources of energy and this has arguably become even more of a priority following the Russian invasion of the Ukraine.

Renewables are arguably now an energy security priority for governments, and it is difficult to see this reversing any time soon.

While the clean energy space has been painful for investors in recent years, there is a strong structural backdrop and cheaper valuations that might well entice investor sentiment should we see further declines in inflation. It is also worth remembering the environment is broader than just clean energy and plenty of these themes have proven useful constituents of sustainably focused portfolios. It is easier said than done but we would encourage investors to think long term and not panic.