Michelle Buckley, CFA, CAIA
Portfolio Manager, Director of Multi-Asset Strategies
As 2022 came to a close, rankings of the year’s best- and worst-performing ESG funds tended to highlight Value’s dominance over Growth and exposure to Technology as key factors influencing U.S. Equity ESG funds’ relative underperformance. Indeed, investors tend to perceive Technology — one of the year’s worst-performing sectors— as less carbon-intensive, making it a favored sector for energy-focused ESG funds. Likewise, the market’s recent pivot from Growth to Value is also a headwind for many ESG-minded investors, as an awareness of ESG criteria, particularly those that affect the environment, have underpinned investments in stylistically growthier companies. These headlines, however, merely scratch the surface.
Investors often perceive Tech companies as environmental leaders because the sector is relatively less carbon intensive than, say, heavy machinery, apparel manufacture or fossil fuel extraction. As some of the world’s largest companies, they have the resources to research, implement, and market their carbon footprint reduction efforts. Nevertheless, Tech has other environmental, social, and governance issues, including excess waste and resource depletion; gender and racial pay equity and customer data privacy; and dual share classes, homogenous boards, and limited transparency. An ESG-integrated research process may identify these risks so that an astute investor may weigh them against a stock’s return profile but maintaining equal or overweight exposure to a sector that begins to underperform will undoubtedly impact a portfolio’s performance in the near term.
As for ESG’s perceived Growth bias, some ESG-minded investors face structural challenges to Value investing, namely, investment-based decisions to divest from fossil fuel extractors or secularly challenged industries like tobacco, both typical constituents of traditional Value portfolios. If an investor concludes that long-term demand for fossil fuel-based energy is in decline or burdensome regulation and a trend toward healthy living has permanently impaired cigarette sales, that investor should also conclude a slowing of cash flow that would make them unappealing investments. ESG integration and Value investing are not mutually exclusive*, however, because ESG is not a style of investing but a research discipline that can be integrated into Value, Growth or Core portfolio construction styles.
Just a few years ago, investment strategists contemplated Value’s demise, following an extended period of Growth’s outperformance. In the eighteen-month period following the market’s dramatic rebound from its March 2020 lows, ESG-integrated funds, many of which underweighted exposure to traditional energy (lest we forget, the Energy sector fell to just 2% of the S&P 500 prior to Covid-related demand destruction), found themselves buoyed by Covid beneficiaries, nearly all of which were the technology companies that assisted our doctor’s visits (telehealth), our work meetings (videotelephony), our groceries (eCommerce), our expenses (payment processors) and our entertainment (streaming) while the world was locked down. As the world reopened and consumers began to travel again, is it any wonder that traditional Energy, a Value-leaning sector, rebounded and Technology, a Growth-leaning sector, abated after nearly two years of outsized returns? This reversal begs the question, does short-term stock behavior change an investor’s long-term thesis? The funds at the bottom of Barron’s 2022 list, for example, outperformed in 2020 and 2021 before falling behind in 2022. This performance is almost entirely driven by the fact that those funds have significantly more exposure to Technology (still more than 25% of the S&P 500) than Energy (now 5%), i.e., because they more likely lean toward Growth, not because their managers integrate an understanding of ESG criteria into their investment selections.