Letter to America: Is ESG investing a bubble?

Some concern that investors could be disappointed if share prices become detached as ESG demand soars.

|

Natalie Kenway

Soaring inflows, stock outperformance, mentions in almost every investment article alongside the words ‘fad’ or ‘trend’… aren’t these normally red flags that a certain area of the stock market is moving into bubble territory?

This is a question that has been posed by many investors in Europe recently following the significant rise in interest in ESG investing and large flows finding their way into the products: Morningstar recently reported assets under management in global sustainable funds topped $1 trillion for the first time, while sustainable funds have also enjoyed significant outperformance during the first half of the year amid a backdrop of extreme volatility as the impact of coronavirus unfolded around the world.

MOMENTUM

But this upturn in performance and unabated demand has prompted portfolio manager of the RWC Continental European Equity Fund to warn investors who are flooding into ESG-oriented funds in the wake of the recent outperformance during the COVID-19 turmoil they could be left disappointed.

“The E in ESG has a lot of momentum right now, and there’s a huge sum of capital going into companies seen as winners in this space,” he says.

“Many companies at the heart of this trade are loss-making, and keep warning on profits, yet shares keep rising. The situation may become more extreme from here, but investors should be aware that the more detached share prices become on the way up, as we are seeing now, then the more extreme the moves can be on the way down.”

While he supports ESG as playing an important role in risk analysis and identifying long-term opportunities, he is raising concerns that ESG investing is “uniquely positioned to distort share prices” especially as European pension funds increasingly embrace responsible investing in their portfolios.

“This ESG trend was already in place at the start of the year, but the tidal wave has continued throughout 2020,” he said.

“As with any bubble, these things are great on the way up, but the more we move away from fundamentals, the worse the outcome for investors is in the long-term.”

He also warns the “basics of finance” in companies such as wind turbine manufacturers, battery makers and hydrogen companies are being overlooked as investors want their piece of the “next big thing” and he is looking for opportunities elsewhere in Europe.

Clearly, as you are reading this on ESG Clarity, we are going to disagree with the notion that ESG investing is a bubble, but it is definitely worth exploring these concerns, particularly amid the explosion in momentum behind sustainable investing this year.

It is not surprising these questions have arisen, and there may even be some pockets where the worries are completely validated: In the midst of a highly successful trade, it is true that some investors can lose sight of fundamentals and buy a theme just because it is ‘hot’ right now. FOMO (fear of missing out) at its finest.

NATURAL TAILWIND

Ben Seager-Scott, head of multi-asset funds at UK wealth manager Tilney, also highlights many ESG investments have had a natural tailwind which has helped them outperform over the last couple of years.

“They tend to avoid some of the worst hit areas such as mining, oil and gas, airlines and energy-intensive industrials, for example, as well as having less in many of the more cyclical parts of the market – but these benefits have general come with improving fundamentals, particularly during the COVID-19 crisis.”

Despite this, from our many conversations with investment commentators from across the world and various asset classes, it is clear ESG investing is not a ‘bubble,’ but a long-term investment theme that will inevitably become part of mainstream investing.

Aegon Asset Management’s Malcolm McPartlin recently summarized the reasons why perfectly. In our first ESG Pathway, an educational webinar series for UK IFAs in conjunction with Square Mile Investment Research & Consulting, an adviser asked McPartlin, “how can we be sure ESG is not just a fad?”

His response: “It does feel like that at times given how frequently the term is used. However, we think the market is actually underestimating the impact ESG will have on economies, companies and financial markets.

“Climate change, access to healthcare, and inequality are mainstream high-profile issues. If you think about major news stories of recent years many are directly related to ESG issues; extreme weather, flooding, drought, wildfires, inequality, racism, data security and abuse.”

He adds that poor governance has sadly led to some major environmental disasters, such as oil spills, and a corporate governance scandal at Wirecard recently led to its collapse.

His point, and what we have continually written about on ESG Clarity, is that companies, governments and individuals are waking up to these issues and changing their behavior.

“Awareness and appetite to do something about these issues has grown,” McPartlin states.

In Europe, consumers are voting with their feet with the war on plastic pollution, shifting to a plant-based diet and changing the way we travel.

As a result, corporations are also changing.

“Corporates are recognizing theses shifts in demand,” says McPartlin, “and changing the way they think about their existence, their very purpose. They are shifting away from traditional shareholder maximization to a mandate more focused on satisfying a wider stakeholder base.”

Furthermore, governments are looking to incentivize sustainable activities and punish unsustainable ones with regulation, taxation and fiscal spend.

“I urge investors to look at the European Commission’s Sustainable Finance Action, which shows how serious they are taking it – the proposals are quite dramatic.”

While such legislation in the U.S. seems be some way behind, the sad truth is if corporations and individuals do not take action soon the planet and financial markets will be negatively impacted.

Seager-Scott adds that the concerns around losing sight of fundamentals are justified, but he agrees ESG is not a fad.

“I don’t think they are in bubble territory at all, and valuations certainly don’t look very stretched (as they would if they were in a bubble). Now it’s reasonably likely that some of the tailwinds will turn into headwinds when the cycle turns, but these are just temporary factors and I think ESG will remain a viable investment strategy for the long-term.”

Those that continue to shun companies or funds with higher ESG credentials may find themselves with a more extreme FOMO in years to come.

Natalie Kenway is the editor of ESG Clarity at Last Word Media.

MORE ARTICLES ON