Analysis-Bear Market Puts ESG Investing To Its First Big Test

Investing based on environmental, social, and corporate governance (ESG) principles became a $35 trillion industry on the back of a long run-up in stocks that lasted from 2009 until the start of this year.

Investors now have to decide whether they will stick with it when making money is no longer easy.

The onset of a bear market this year, driven by rising interest rates and concerns over a potential recession, is testing investors' ESG commitments. U.S. sustainable funds recorded a rare monthly outflow of $3.5 billion in May, according to Morningstar.

Even before then, inflows to these funds had slowed. They took in $7.5 billion in the first five months of this year, compared to $35 billion in the prior period.

Nevertheless, Alyssa Stankiewicz, Morningstar's associate director of sustainability research, said outflows from ESG funds would have to be sustained for the weak demand to be more than a "hiccup."

"If we were to try to claim that demand for ESG funds is materially deteriorating, you would want to see that demand is sinking faster, and for an extended period of time, than the broader market," Stankiewicz said.

ESG equity funds faced headwinds in their portfolios on two fronts this year. Technology stocks, which ESG funds tend to be overweight on because they are perceived as more environmentally friendly, underperformed the broader market. And oil and gas stocks, which many ESG funds are underweight because of concerns about climate change, outperformed thanks to a rally in energy prices following Russia's invasion of Ukraine.

While U.S. sustainable funds have outperformed a representative group of other funds by 1.4% annually over the five years to June 30, they underperformed the broader market by almost 2% during the first half of 2022, according to Morningstar Direct.

Investor surveys, seeking to gauge their future response to the downturn, have come up mixed.

A survey published by the Journal of Financial Planning and the Financial Planning Association last month found that 28% of financial advisers planned to increase their use or recommendation of ESG funds over the next year, up from 24% in 2021. But it also found that 15% planned to decrease usage over the same period, compared with just 4% in 2021.

An RBC Wealth Management survey of 976 investors based in the United States published in April found that almost half of them said financial performance and returns were a higher priority than ESG impact, up from 42% who said so last year.

Peter Essele, head of portfolio management for investment adviser Commonwealth Financial Network, said ESG investors tend to have long investment horizons that make them "sticky" to the asset class.

"They tend to be less performance-focused than your traditional investor, so I think there's a willingness to commit and stay with companies through periods of volatility," Essele said.

That view is shared by many on Wall Street, including investment bank Morgan Stanley, whose equity analysts said last month that the "softening in ESG sentiment" did not represent a "structural slowdown."

POSITIONING FOR AN UPSWING

Tim Hughes, managing director at investment adviser Wealthspire Advisors, said he found that client interest in ESG investing has been on the rise for the last year. "We have seen underperformance, but I kind of feel like it's expected, and expectations were managed as such. I frankly haven't received much pushback (from clients) at all," he said.

It's possible that market trends will come to favor the portfolios of ESG funds in the coming months. Technology stocks, for example, have staged a small rally since last month that would boost ESG funds were it to pick up steam.

Cheryl Smith, economist and portfolio manager at ESG investor Trillium Asset Management, said periods of sluggish economic growth often favor companies with steady growth prospects, including those in the ESG-friendly technology and healthcare sectors.

Amber Fairbanks, portfolio manager at sustainable investment firm Mirova US, said she was not investing in ESG just "to feel good" and that she saw opportunities in this environment to score returns that beat the broader market.

"We're looking at it as a source of outperformance, and that's something that I think more and more investors are starting to recognize," Fairbanks said.