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Longstanding ESG fund managers — there are a few around — should compare experiences with managers of technology funds at the beginning of the dotcom boom over 20 years ago.
Everybody got the tech bug, until it ended in tears. Whether investing on environmental, social and governance (ESG) criteria amounts to a bubble or not, ESG investors should keep sight of their financial objectives.
During the dotcom bubble the investment industry was transformed. Investment bank analysts ditched their suits for the jeans and T-shirts uniform of Silicon Valley entrepreneurs, while claiming that the future was all about technology, media and telecoms companies.
Tech stocks soared and non-tech companies rebranded to get in on the action. It seemed that almost any listed company launching a website saw its share price rise. New money, fuelled by relatively low interest rates, chased start-ups without revenues, let alone the prospect of profits. Innovative methods to value companies far into the future were promoted, implying further upside to share prices.
Technology funds launched and index providers obliged with new benchmarks. The demand for tech investments vastly exceeded sustainable supply, while “old economy” stocks, which generated sales, profits, and dividends, were sold. It all seemed very credible and exciting. We know how it ended.
ESG investing has increased substantially in the past three years or so. It is an exciting time.
Estimates of its growth vary. Morningstar reports that a net $51.1bn flowed into US sustainable funds alone in 2020. In early April 2021, BlackRock, the investment group, achieved the largest ETF launch to date, raising $1.25bn for its new US Carbon Transition Readiness Fund.
Existing funds are rebranding as ESG-focused. Many companies are rushing to align with the trend. New sustainability benchmarks have been developed. Green bonds are being issued at a premium to their conventional equivalents from the same issuers.
Yet investors are still buying. Are we in a bubble of sustainability assets? Patrick Pouyanné, chief executive of Total, the French energy group, declared in February that renewable energy valuations were “just crazy today”, with oil companies buying in their rush to demonstrate they were also climate friendly. His comments were met with barely more than a collective shrug. The demand for sustainable assets has exceeded supply, driving up prices and reducing future returns.
In time, the supply of credible “sustainability investments” will increase and companies will adapt to investor and consumer demands. Some investors will pay too much and experience disappointing returns while others will do well. This is how markets work. The tech boom led to substantial gains to the consumer. For example, online retailing is now part of life; 20 years ago, it was innovation. Many investors lost substantial amounts of money but some innovative firms became the Big Tech giants of today.
The case for ESG is not made by short-term performance, however welcome it may be. ESG equity funds may have performed relatively well last year compared to conventional benchmarks, but many would have benefited from underweight positions in oil stocks and, perhaps unintentionally, from exposure to large companies with strong quality and growth characteristics. Likewise, it would be unfair to declare that ESG has failed because it had a bad quarter. What matters is the extent to which ESG funds meet their investment objectives and financial return expectations adjusted for their ESG criteria. If they do this, the case is made.
An investor might choose to invest in a higher-risk prospect which could succeed and, say, fight climate change, or fail with consequent loss. There will also be times when responsible investors will accept lower returns than otherwise apparently possible, partly because they will consider external costs to society or they will ethically exclude sectors that at times will perform well. But that is very different to relaxing investment discipline, either in the management of active funds or in asset allocation decisions.
The Business Roundtable, an organisation of large US companies, announced in 2019 that shareholder value would no longer be its members’ sole focus. Instead, with ESG enthusiasm soaring, they would attend to a range of stakeholders. That was not necessarily good news.
History provides many examples of managements focusing on something other than sustainable investment returns, such as the value of their stock options and executive pay, empire building, or political influence. These stories do not usually end well for investors; if shareholder returns are downplayed too far, investors are ill served. Unless a business is sustainable financially it will not be around to exercise responsibility. The prize is found in integrating financial and ESG objectives.
The case of Danone is instructive on the role shareholders can play. A company with a declared and deep commitment to social purpose was nevertheless under pressure to improve financial returns, including from an activist shareholder committed to ESG. The result was the removal in March of Emmanuel Faber, the joint chair and chief executive. Whether or not one agrees the Danone activists were being fair, the best ESG fund managers will be passionate believers in investing responsibly in a sustainable market economy, but sceptical of all they survey, including chief executives and companies bearing ESG gifts but not delivering financial returns.
History is not preordained to repeat itself, but ESG investors should pay attention to prospective financial returns as well as other potential gains to society. If they are not aligned, someone will be paying over the odds.
Stephen Beer is vice-chair of the Church Investors Group. This article represents his personal opinion