Outside the Box: ESG funds are lagging the S&P 500 — why that’s good news if you own them

This post was originally published on this site

Conventional wisdom said the start of the Biden administration would usher in a new era for investors focused on environmental, social and governance (ESG) issues. Indeed, within days of President Joe Biden’s swearing in, the White House rejoined the Paris global climate accords, cancelled the Keystone XL pipeline, and established two new senior administration posts dedicated to climate issues. Meanwhile, sustainable investing strategies have continued to attract record inflows. 

Yet investors seeking to make positive environmental and social impact with their capital may have noticed something else: Since Biden took office on Jan. 20, many ESG-focused stock funds have been trailing the broad U.S. market. 

The FTSE4Good U.S. Select Index , which screens for U.S. stocks based on environmental, social, and governance factors, was up 11.6% since Jan. 20 through June 30, while the S&P 500
SPX,
-1.91%

rose 12.3%, according to investment researcher Morningstar. It’s the same story globally. For example, the MSCI ACWI Sustainable Impact Index was up less than 1% since Biden took office, while the MSCI All-Country World Index gained 8.5%.

In the energy sector, the results were even more pronounced. Traditional oil-related stocks in the S&P 500 gained more than 25% from Jan. 20 through June 30, but shares of sustainable companies in the S&P Global Clean Energy Index — which includes solar, wind, and smart grid exposure — fell almost 25%.

Is the market sending ESG investors a signal? Actually, no. Such counterintuitive performance was to be expected, and it’s welcome as it demonstrates the normalization of ESG considerations alongside other fundamental factors in investing, including:

1. Reversion to the mean: Investors must be mindful of how well ESG-related investments had been performing. For instance, the iShares Global Clean Energy ETF
ICLN,
-1.74%

returned 195% over the five years through June 30, according to Morningstar. That time period includes the entire Donald Trump presidency, which wasn’t exactly seen as a proponent of sustainable investing. Over the same time, the Energy Select Sector SPDR ETF
XLE,
-4.17%
,
which invests in large-cap oil-related stocks, lost 1%. 

As a result of years of outperformance, clean-energy stocks were trading at a 19% premium to the broad market at June 30, based on average price/earnings ratios, while solar stocks were at a 42% premium to the market as a whole, according to figures tracked by Morningstar. At the same time, oil and gas stocks were trading at a near 15% discount to the S&P 500. 

This shows that ESG investments are subject to the same forces, including valuation risk and reversion to the mean, that affects all other securities in the market. So the recent underperformance is to be expected. 

2. The market’s counterintuitive nature: History shows that the markets tend to go against conventional wisdom, especially when politics are involved. For example, Big Oil was supposed to thrive under the Trump administration, which rolled back Obama-era regulations on the oil and gas industry. Yet energy stocks lost around 30% of their value under Trump’s presidency, after gaining close to 100% under Obama’s two terms.  

Conversely, gun stocks were supposed to sink under the Obama administration. Yet shares of firearms manufacturer Sturm Ruger & Co.
RGR,
-0.38%
,
soared more than 740% during Obama’s presidency, producing more than three times the gains of the broad market. By contrast, Sturm Ruger gained 38% during the Trump administration, or less than half the gains of the S&P 500 index, even though Trump was seen as a staunch proponent of gun rights.

The real lesson of ESG performance

Though ESG factors are essential for risk management and are becoming an essential part of securities analysis, investors have to be realistic: ESG investments, like any other asset, will go through periods of underperformance even if they can outperform in the long run, as several studies have shown.

Bouts of ESG underperformance are actually a positive development, as it underscores the fact that ESG isn’t some gimmick or silver bullet when it comes to investing. Instead, this shows the natural evolution of sustainable investing from novel idea to thematic tactic to a core strategy that is subject to the same fundamental market forces that affect all other mainstream, long-term holdings. 

Vikram Gandhi is a Senior Lecturer at Harvard Business School, where he developed and teaches HBS’ first course on impact investing — Investing: Risk, Return, and Impact. 

More: Goldman Sachs launches an ESG ETF with a go-anywhere, any-size approach

Plus: 401(k) investors will soon be able to choose ESG Funds