Time to place ESG ‘underperformance’ in context

Short-term performance can underestimate or dismiss larger factors

Newton’s Third Law of Motion states that for every action there is an equal and opposite reaction. Investing in investments that have sustainability criteria has accelerated in the past decade – there’s now more than $4trn in total global assets.

With this massive capital transfer into ESG investments, there’s been an increasing backlash to the sector’s growing dominance. This has been especially strong in America, where a coalition of attorneys general and elected officials are threatening to place restrictions on public pension funds on investing in green funds.

One of the main arguments used by these anti-sustainability investors is that by mandating or even favouring ESG investments, institutional investors are moving away from their core mission of delivering the best possible risk-adjusted returns for their members. Carbon intensive industries, they argue, such as mining and energy production, have the ability to fund the pensions of millions.

The latest return figures have added fuel to the fire. The first two quarters were bad for equities, but ESG funds performed worse than average. Global ESG firms underperformed their benchmark by 2.5%, according to our data. Nearly four in five –78% of ESG equities – did worse than the benchmark.

The problem with this argument – ESG products are bad investments and take returns off the table for hardworking pension funds investors – is that it relies on a very narrow interpretation of the data. Looking at both a short- and long-term horizon, the figures are much better. In the third quarter (the latest figures available), global ESG median return was -6.09% compared with a broader global equity peer group return of -6.87%. Nearly two in three funds – a full 65% outperformed the index.

Clean energy funds did particularly well in the third quarter. Several companies had positive performance, far outpacing the market as a whole. But even removing these firms, ESG still outperforms the index and broad peer group mainly due to style similarities.

More important is looking at longer term results. On a one-year basis, 63% of global ESG products underperformed. This reflects the overall underperformance of growth products, as 73% of these investments underperformed the index. But looking at a three-year time horizon is different. Seventy-four percent of ESG products outperformed the benchmark, with a median return of 5.9%. While environmentally focused products account for 30% of the global ESG universe – they accounted for 40% of the products that outperformed – again driven by clean energy/energy transition.

Influential voices both inside and outside the investment industry have noted that short-term performance can underestimate or dismiss larger factors. Investment managers are increasingly needing to look at how companies will be impacted in the medium and longer term by finance. Sustainable factors can be intertwined with overall performance – they are not necessarily in opposition.

Investors are increasingly integrating sustainable-linked factors into their overall investment process. Managers can create custom portfolio based on investor appetite across traditional and sustainability factors placed together, to find an investment style that makes sense for the individual. This is a nuanced and tailored discussion, which means as always it’s worth going beneath flashy headlines to focus more deeply on actual results.