ESG keeps pulling in lots of money, even as strategy is no longer outperforming as much

Published Sat, Oct 30 20219:56 AM EDTUpdated Sun, Oct 31 20218:20 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

ESG investments have lost some of their pop. But they should still see strong inflows, even though they have outperformed at a slower pace this year. The stocks that are best-rated by ESG rating firms still command a premium, as more and more money is flowing into funds that focus on ESG, short for environmental, sustainable and governance issues. According to Bank of America, $3 out of every $10 going into global equities is being directed into ESG. Through September, global ESG funds took in $230 billion this year, up 111%. RBC ESG strategist Sara Mahaffy says the performance this year of dedicated ESG equity funds has not been as strong as recent years. "The track record so far this year has been a little bit more mixed," she said. "The percentage of funds beating their perspective benchmarks has been weaker than prior years. Three- and five-year stats still look in favor of sustainable funds but year-to-date they look more mixed." Year-to-date, 51% of actively managed sustainable funds were beating their benchmarks, compared to 54% over three years, according to RBC. Just a third were beating as of July of this year. As of late September, U.S. actively managed sustainable funds for the year so far had a median absolute return of 20.9%, compared to 19.7% for U.S. actively managed large cap stock funds. But for 2020, the sustainable funds had a relatively higher median average return of 19.5%, compared to 14.2% for other equity funds. "I wouldn't say it's been weak," she added. "The broader theme is we're seeing a shift towards sustainable investing." The iShares MSCI USA ESG Select ETF was up 24.9% year-to-date. The fund invests in companies from a universe of S & P 500 and Russell 1000 companies. The Vanguard FTSE Social Index Fund Admiral, which also invests in U.S. stocks, has among its top holdings Apple, Microsoft , Alphabet , Amazon and Facebook , now Meta Platforms. The fund was up was up 21% year to date, versus the 22.4% gain in the S & P 500 this year so far. Mahaffy and other RBC strategists have tracked the leading highly-rated stocks in ESG funds, but they also look for opportunities among stocks that have good ESG profiles but are not yet widely held by the funds. Bank of America analysts found that on an individual stock basis, the top-rated ESG stocks are being granted less of a premium in the market this year, though they have improved recently. "The premium has come down significantly from the peaks and trends you had over the last couple of years," said Panos Seretis, ESG strategist at Bank of America. Seretis pointed to an analysis of the relative price-to-earnings premium for companies that were rated in the top fifth for ESG by MSCI, versus the bottom fifth. MSCI is one of a handful of firms that rates stocks for ESG values. The relative P/E premium for the highest-rated companies has fallen from a high of 56% in 2019 to 25% currently, according to BofA. One reason may be that investors are doing more analysis and investing beyond the top tier, says Seretis. "A lot of investors are looking under the hood of the ESG ratings, and they're trying to make their own assessments," he said. RBC's Mahaffy said picking among the leaders, or stocks that are top-rated ESG names, is a good strategy for investors. RBC analysts formed an ESG leaders list by screening for companies that had solid ESG credentials and were rated in the top quartile of their sector and regional peer group. The stocks on the list were also popular with actively managed sustainable funds and dedicated passively managed sustainable funds. The list includes tech names like Microsoft, Accenture, Salesforce.com and Adobe . Walt Disney, Starbucks , Coca-Cola, Mastercard , Nextera Energy, American Water Works , S herwin-Williams, Gilead, Moody's , Masco and Roper Technologies are also on the list of ESG leaders. "I think in terms of the valuation angle, because of the fact there is still a kind of scarcity value with these ESG leaders, the continued flows we're seeing into the space does provide valuation support," she said. While overall ESG performance may have been less robust this year, that does not preclude it from outperforming in a bigger way in the future. "They'll sometimes take these mini dips but they'll bounce back," she said. RBC's list of 'contenders' are the stocks that are not yet favored by the funds and have improving ESG profiles. Companies recently added to this list include Daimler, General Motors , Next PLC, Factset Research Systems , Cintas, Dollar General, Plug Power, AB SKF , SSE PLC, EDP Energias de Portugal , Public Service Enterprise Group and Dropbox.

A wind farm shares space with corn fields the day before the Iowa caucuses, where agriculture and clean energy are key issues, in Latimer, Iowa, February 2, 2020.

Jonathan Ernst | Reuters

ESG investments have lost some of their pop. But they should still see strong inflows, even though they have outperformed at a slower pace this year.