It is not controversial to suggest that it may be a more favourable moment for value stocks. After a decade where low interest rates have flattered growth stocks, their value counterparts have outpaced them by around 14% over the past 12 months. However, less widely discussed is the extent to which this may dent ESG and sustainable strategies as the environment changes.
Damian Handzy, managing director, analytics at Confluence, says there is a question mark over what happens to ESG strategies in a high interest rate environment. ESG is, by and large, a phenomenon of the past decade, so has only known an environment of low rates. He adds: “No-one knows, because it hasn’t been tested.”
There is a concern that ESG strategies are more aligned with growth and may struggle to perform as rates rise. Handzy says: “ESG is not about profit. Similar to growth strategies, its benefits lie further down the road. As such, it works better when ‘down the road’ is more valuable. As such, the rotation from growth to value could affect ESG strategies.”
The sector weighting of the value and growth indices seem to bear out this view. The MSCI World Value index has Exxon Mobil and Chevron in its top 10 holdings and a 10% weight to energy. It also holds a 22% weighting in financials, which have also been a problematic area for ESG strategies because of the extent to which they finance ‘difficult’ industries.
In contrast, the MSCI World Growth index has Apple, Microsoft, Invidia, Tesla and Alphabet among its top 10. Energy is just 1.4%, utilities just 0.3%. Against this sector backdrop, it is perhaps unsurprising that ESG is seen as aligned to growth.
Alex Wright, manager of the Fidelity Special Values trust, says that the outperformance of growth and the outperformance of ESG may have been conflated: “It may be that people thought ESG was adding value, but growth was the key factor. There is a huge overlap between what scores well on an ESG basis and what scores well on a growth basis.”
Handzy says that the data is inconclusive as to whether ESG outperforms on its own merits. “Our statistics suggests that there is a slight outperformance, but only among those companies with the very highest ESG scores – the top 10%.”
Money flowing in and out of ESG strategies has also complicated the picture. Wright says: “The weight of money going into ESG and sustainable strategies in 2020 and 2021 definitely had a big effect on share prices. We saw UK ESG funds that were taking a lot of money were often buying the same stocks and were not particularly valuation sensitive. They were building those stocks up to very high valuations.
“That was difficult for my strategy. We had a lot of financials, which tend to score badly, plus small caps, which – for disclosure reasons – tend to score badly. Oil is also a big part of the fund. Imperial Tobacco was another one. That has gone into reverse over the past year. Some ESG funds are seeing quite big outflows. At the moment, having a high ESG score is generally quite negative because of the weight of money coming out.”
Marcel Stötzel, manager on the Fidelity European trust, says a similar phenomenon has been evident in European markets. He points out that ESG-favourites such as wind farm group Orsted were bid higher. “There were not enough assets to support fund flows into ESG areas. There was a hype cycle, following by a tough period of disillusionment.”
However, he believes that many of these ESG target stocks are now trading at reasonable levels: “I wouldn’t say they are undervalued, or overvalued, but seem to be at a steady state.”
The reality is that ESG is probably more nuanced than aligning to growth or value.
In a review of industry research, Toby Belsom, director, investment practices at the PRI, and Laura Lake, former CIO of Breckinridge Capital Advisors, concluded that correlations vary over time and between industry sectors: “For example, research on social factors seems to show an increasingly strong correlation with equity returns. This correlation is shown to vary between geographic regions, while differences in correlations between listed equity returns and ESG rankings between industrial sectors also records interesting results. For example, research shows governance metrics are of more significance in the financial sector; environmental factors show a strong significance in the energy and materials sectors; and social factors are important in consumer discretionary business.”
It is also worth noting that the environment in which ESG has grown up has had an influence. There hasn’t been significant demand for value strategies, ESG or otherwise, so those funds have not emerged. However, there are now credible value-focused options emerging – Schroders, for example, launched its Global Sustainable Value Fund in July 2021. ClearBridge has a large-cap ESG value strategy.
There is no reason why value and ESG cannot co-exist or that ESG should be aligned to specific sectors, just as there is no inherent reason why ESG strategies cannot perform in an environment of higher interest rates. That said, it removes a tailwind for ESG strategies and ESG-focused managers may need to be smarter than simply targeting US large-cap technology companies. Investors may have to pick more carefully from here.