Refinitiv’s Robert Jenkins analyzes what ESG funds are actually investing in, and why tech stocks play such a significant role in the most active U.S. ESG funds and sustainable investing.
- ESG funds are tending to outperform their benchmarks and the market, and sustainable investing is consequently gaining more industry attention.
- Robert Jenkins, Head of Refinitiv Lipper research, has analyzed 12 of the most prominent active U.S ESG funds that hold $33bn in AUM.
- These types of funds have been evolving in terms of their sophistication and type of investments they include.
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Sustainable investing, also known as responsible investing, has recently grown in prominence. Asset managers have realized both the economic and social value of investments that meet ESG criteria, for the long term benefit of our society and environment, and also for increasing investor appetite.
Funds that mark themselves as sustainable investments, are supposed to steer money towards companies with strong environmental, social or corporate governance standards.
As such many investors are now seeing if their investment manager is a signatory of Principles for Responsible Investing (PRI), the world’s leading proponent of responsible investing. It currently has 1,750 members, representing about US$70 trillion of investments.
The PRI has six main principles, three of which concentrate on integrating ESG into investment analysis and decision making.
The evolving ESG fund market
ESG, or socially responsible investments (SRI), funds have been saddled with the reputation of being investment vehicles that can potentially deliver on values but often at the expense of performance.
A recent report on ESG funds by Robert Jenkins, Head of Refinitiv Lipper Research, analyzes how as ESG funds have been evolving, their performance had much to do with the negative approach to screening out companies and industries that many early ESG/SRI funds employed.
Companies that were often excluded also tended to be in industries that had generally stable cash flows and fairly decent performing stocks, such as alcohol, tobacco, gambling and, of course, energy-related stocks.
Eliminating these industries tended to reduce the diversification of funds and create more volatile performance for investors, while also losing the benefit of the often strong financial performance of these companies.
In short, ESG/SRI funds of old had a performance problem, with the possible exception of the occasional negative sector events that provided brief benefits, such as a drop in energy prices or lawsuits against tobacco companies.
As ESG funds have matured and stock selection has become more focused on positive ESG stories over negative screening, fund performance has improved. In fact, it’s been well reported of late that ESG funds are tending to either match or even exceed the performance of non-ESG funds.
Active U.S. ESG funds
Jenkins’ analysis showed that of the 12 of the most prominent active U.S ESG funds that hold $33 billion in AUM, on average, more than 40 percent of these funds’ investments were housed in their top 10 holdings.
Further analysis showed that the top 10 holdings all seemed to have settled on a very similar line-up of top names. Microsoft, in particular, turns out to be the widely agreed upon darling of ESG-minded investing, having its place as the number one holding in 11 of the 12 funds.
Microsoft can be found topping the charts across funds with themes such as dividend, quality, global opportunities, and large cap. And it is often accompanied by Apple and Amazon in those same themed funds. In fact, the dominating profile among all the funds reviewed was the presence of well-known tech names.
What role do FAAMG stocks play in sustainable investing?
Camilla Hodgson, continues this observation in an FT Article, ‘Funds branded ‘ESG’ are laden with technology stocks’, and looked at how a particular group of stocks were being selected within these types of funds.
FAANG consists of Facebook, Amazon, Apple, Netflix, and Google’s parent Alphabet. FAAMG, meanwhile, is made up of Facebook, Amazon, Apple, Microsoft, and Google/Alphabet.
In the year to 27 July, eight of the 10 best performing large cap U.S. funds that incorporated ESG metrics as a key part of their selection process had either Apple, Amazon, or Microsoft as their biggest holding, according to Morningstar data.
Hodgson noted that separate data from Refinitiv supported this. Of the top 10 performing funds that it labels ESG in the year to 30 June, 19 percent of assets were in FAANG stocks or Microsoft.
Why are tech stocks so appealing for ESG portfolios?
Jenkins concludes that a likely reason for all this tech is simple: These companies tend to not be known as carbon emitters, and therefore seem like safe bets to front up an ESG portfolio. And so if your investment goal is focused on climate, this may be just what you’re looking for.
It doesn’t hurt that these same stocks have been on a years-long bull run, and that they are thoroughly outpacing market averages and most typical stocks. Microsoft is up more than 300 percent in the past five years, and Amazon has increased more than five-fold in the same period.
In terms of other sector coverage, Jenkins observes that one sector the active managers have clearly been actively banishing from their portfolios over the past few years is all things energy.
In fact, only one of the 12 funds had any allocations to the energy sector, and that one fund had less than 2 percent worth of energy holdings. At the other end of the spectrum, the most overweighed sector relative to the S&P 500 was technology.
Beyond just energy, ESG funds tend to be lighter on utilities.
Watch: Refinitiv Perspectives LIVE — ESG Investment, a cure all for Asset Management?
Performance of ESG stocks
The Refinitiv white paper ESG vs financial performance of large cap firms, produced in partnership with Probability & Partners, looked at large cap stocks correlating ESG scores, returns, volatilities, and market value resulted in two key themes across all four regions within the analysis.
- Correlations between ESG scores and market value were positive and significant for the period of 2010 to 2018 across all regions. This suggests larger firms exhibit better ESG performance because they have more means by which to invest in sustainability, and therefore improve their scores.
- Correlations between ESG scores and volatility of returns were negative and significant for the same period across all regions. This suggests that firms with high ESG scores are less volatile than their lower-scoring counterparts.
As ESG funds are tending to outperform their benchmarks and the market, they are certainly gaining more industry attention.
Once ESG investing was seen as a periphery investment approach for many asset managers, but it is now very much part of their main agenda.
As such, these funds have been evolving in terms of their sophistication and type of investments they include. In addition, because they have recently appeared to be less volatile, it could place them as an all-round performer, offering good competition for any absolute return fund. However, investors would be wise to investigate the source of any positive returns.