Is there a bubble in the ESG market?
What is ESG investing?
ESG Investing focuses on identifying companies that work towards improving the environment, addressing social inequality and promote good corporate governance. It is about investing to make a positive difference, focusing on companies that are campaigning to have a positive impact on the world.
ESG investing has hit the headlines for a number of reasons in recent years, but the concept has been around much longer. This type of investing has gone by, and still goes by, a number of different labels including Ethical investing, Sustainable investing, Responsible investing and Impact investing.
Unlike Ethical investing, which focuses on avoiding companies with links to things such as gambling or tobacco, ESG investing applies a positive screening approach when selecting investments; assessing and rating companies on whether their practices, production and overall business models demonstrate a positive trend to comply with ESG principles.
ESG fund managers generally adopt a forward looking, positive approach when considering potential companies for inclusion in their fund. This means rating their companies on all E (Environmental), S (Social) and G (Governance) elements and considering what the intent of the company is and what actions they are taking to ensure they generate measurable social or environmental impact alongside a financial return.
The rise in ESG Investing
In the last few years, ESG investing has grown significantly both in terms of the amount of money being invested and the availability of investment opportunities.
In July this year, ESG funds accounted for 90% of inflows. Furthermore, investors increasingly believe companies that perform well on ESG are less risky, better positioned for the long term and better prepared for uncertainty.
Performance is not being sacrificed either, six out of ten sustainable funds delivered higher returns than equivalent conventional funds over the past decade, according to a study that undermines claims that investing based on environmental, social and governance principles hampers performance.
Investors have realised that there are plenty of ESG funds performing well and they want to be part of this journey so that their monies are being used to create a positive contribution to the world. Companies are aware of the social pressures to act in a more positive way due to changes in investors behaviour. Governments are also trying to promote a better world, with COP26 (2021 United Nations climate change conference) being hosted in Glasgow later this year.
Is there a bubble in the ESG market?
With ESG funds performing better than traditional funds, and plenty of inflows into these funds, the question now is, is it all too good to be true? Could there be a bubble in the ESG market?
Firstly, a bubble in investment terms refers to a situation where the price of something is exceeding its fundamental/ actual value by a large margin. We’ve had the dotcom bubble and the housing bubble in recent years and some fear ESG could be next.
There is concern regarding the speed at which ESG-focused funds have soared and now account for a third of assets professionally managed. As the concept becomes increasingly popular are investors overconfident and continuing to invest heavily without strategic reasoning?
There is also the concern regarding greenwashing. Greenwashing is when a fund/ company claims to be doing more for the environment than they actually are on closer inspection. Companies such as Coca-Cola have recently been accused of this by suggesting that recycling their bottles is one of the solutions to the plastic problem.
However, Greenpeace have said that Coca-Cola are trying to sell us that recycling is the solution to the problem they are creating by continuing to produce single-use plastics There is a risk that if a fund is in fact greenwashed and exposed as such, the performance will drop and it could have an adverse effect on investors.
It’s important therefore that investors research whether funds are investing based on ESG principles or are merely taking advantage of good PR and marketing and labelling their funds ESG friendly. Being invested in the latter could prove costly as stated above.
What do TPO think?
There are arguments that there is not a bubble in the ESG market. If you were to look at the world’s largest ESG-flagged Exchange Traded Fund’s (ETFs), the top holdings are Apple, Microsoft, Amazon, Facebook, and Alphabet. The world’s largest 'conventional' ETF, however, has the same five stocks in the same order, albeit with slightly different weightings.
This shows that, investing in ESG portfolios means you are holding well run companies, not companies that are different to the norm. There is a wider question around technology firms being overvalued, however, not necessarily ESG. For example, Tesla raced up to 750% during last year, which does raise the question, how long can this go on, before a potential correction?
Many do not see it as a bubble, more a ‘tectonic shift’ that is accelerating, rather than a bubble about to pop. This also plays into the argument that ESG is not a sector or market it is its own right. It is not a trend; it is an investment strategy. In a sense, ESG investing is an extension of the quality factor in equity investing—that is, the tendency of high-quality stocks with typically more stable earnings, stronger balance sheets and higher margins to outperform low-quality stocks.
MSCI have found that outperformance of ESG funds was mainly driven by companies’ earnings and better dividend yields, rather than rising valuations for the companies, which normally lead to price bubbles.
Finally, the argument against ESG being a bubble is because the demand is due to investors knowing they want to build a better future and world. Many are investing in these funds as they are investing in sustainable, long-term companies.
There is a growing view that in a few years, there won’t be ESG investing, there will just be investing. Companies that list on global exchanges will need to adhere to ESG principles to attract investors and capital. In fact, many will see ESG investing as the norm for better returns and to help restore the planet. A survey conducted by Core Data found out that of 200 global fund managers surveyed, 63% predicted that all funds would incorporate environmental, social, and governance factors in five years, while with 81% of U.K. respondents reporting that they made ESG more of a priority.
If you would like to learn more about ESG, we invite you to watch our webinar on the 16th November where will be discussing ESG in detail.
Please note: Investment returns are not guaranteed and you may get back less than originally invested. Past performance is not a guide to future returns.