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Most selectors willing to take performance hit for ESG

More than two thirds of European fund selectors are willing to suffer one year or more of underperformance in an environmental, social, and governance (ESG) strategy, according to our research.


Underperformance over a medium-term timeframe does not mean that an ESG approach is failing as socially-responsible investing requires greater patience, according to a majority of European fund selectors.

Of the 229 continental fund selectors surveyed by Last Word Research in June, 21% were willing to suffer more than two years of underperformance.

Meanwhile, 16% said they would only experience less than six months of underperformance in an ESG strategy.

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Source: Last Word Research

A further 59% said they thought that ESG screening enhanced investment performance, 50% said they would either increase slightly or considerably their allocation to ESG strategies, and only 3% said they would reduce.

Underperformance patience

Financial services group Nordea’s senior investment strategist, Erik Nordenskjöld said patience was needed with ESG strategies and that underperformance over a set period did not mean ESG did not produce results.

Nordenskjöld said other factors could drive underperformance and that it was extremely difficult to be sector neutral when a fund was ESG driven.

He said for example that ESG strategies did well when oil prices plummeted because the fund was naturally underweight oil majors.

“I’ve heard of this idea – which I have not seen work yet – to use ESG in portfolios to work as a tail hedge. So, if you don’t invest in major companies such as BP and Enron, you might have a slight underperformance for some time,” he said.

“But when major events hit, your portfolio will not suffer and you will sort of get your revenge but you need to wait for these tail events.”

Nordenskjöld noted that these tail events did not occur often so patience was needed with underperformance.

“Even value can underperform growth from time to time, but over the long term they should provide higher returns,” he said.

Beauty of boutiques

FiNet Asset Management’s head of portfolio management, Frank Huttel said two or three years of underperformance was not an issue as ESG strategies outperformed in the long run, and he had no interest in swapping out an underperforming ESG fund for a non-ESG strategy.

When looking for ESG funds Huttel said it was easy to find genuine ESG funds if selectors had a good database and knowledge.

Huttel suggested selectors could attend conferences, read articles, and network to gain knowledge and combine that with data to find a range of good funds.

However, Huttel said that he did not like “best in class funds” from large fund houses and that he preferred boutique houses such as Germany-based Ökoworld.

“Ökoworld has been around for 30 years and they only have five funds which means if they make a mistake they’re gone. The whole business model is based on an ESG belief and they have a reputation to uphold,” he said.

“If a large house like Blackrock launches a fund and it is not successful it disappears and does not make too much of a difference to the business.”

Huttel noted that boutiques were more likely to truly believe in ESG, were easier to communicate with, and were generally more flexible.

“Big fund houses also always change management every two to three years but in the boutiques space they rarely change,” he said.

“However, the problem with boutiques is that resources are s always an issue in terms of research capacity.”

Ökoworld funds v sectors performance three years to 30 June 2018

Okoworld funds v sectors three years to 30 June 2018

Source: FE Analytics

Huttel said he was invested in three Ökoworld funds – Klima C, ÖkoVision Classic A, and Growing Markets 2.0 C.

According to FE Analytics, over the three years to 30 June 2018 all of the funds beat their respective benchmarks in terms of cumulative returns.

The Klima C fund returned the best at 28.8%, followed by ÖkoVision Classic A at 21.08%, compared to the funds’ ethical equity sector that returned 11.5%.

The Klima C fund had its highest sector weighting in basic materials (60.5%) whereas the ÖkoVision Classic A had health care (24.5%) as its highest weighting.

The Growing Markets 2.0 C fund returned 7.5% over the same period compared to its emerging market equity sector that returned 3.7%.

The fund also had its highest sector weighting in health care at 21.9% followed closely by telecom, media and technology at 21.2%.

Alpha driving ‘warning flag’

Nordenskjöld said a ‘warning flag’ regarding ESG strategies was if a fund manager was focused on using ESG to drive alpha because it did not necessarily mean that their priority was socially-responsible investing.

He said while alpha would generate in the short-term selectors needed to think about what affect it would have in the long run.

“For example, if you invest in a firm from a low labour cost country with low labour protections for workers, once the country starts to develop their labour market then your competitive advantage will disappear and your profitability will plummet,” he said.

“You need patience with ESG investments because during downturns ill-governed companies will suffer.”

Nordenskjöld noted that he once met with a fund manager that was very specific on generating alpha and made it a point to mention that it was just as good as investing in a “normal” fund.

“I don’t see the point of doing ESG this way – it should be different. They should have a different angle. The overall return might not be very different but alpha shouldn’t be selling point,” he said.

Nordenskjöld said he thought of M&G Investments as a market leader in ESG as they had embraced ESG into their “normal” portfolio management and were very well structured in how they found ESG drivers. He also said he was impressed with PIMCO and how they managed their aggregate bond fund which was ESG focused.


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