European investors seem to have lost faith in European equity funds, as investor sentiment has been crushing lately.
According to the latest Last Word Research from April 2020, the sentiment of European fund selectors to buy European equity funds over the next year is falling (see chart below).
Source: Last Word Research
Daniel Pereira, investment research analyst at Square Mile Investment Consulting and Research, explains that sentiment towards European equities has been poor for several years now.
He says: “European economies have been posting low or even negative growth, topped off by a higher unemployment rate when compared to other major developed economies.”
Cameron Brandt, director of research at EPFR Global, believes that the European export sector has been the “strongest part of its investment case post the great financial crisis”, but was struggling from the Sino-US trade dispute.
Adding to this, he sees the sector impacted from the pandemic as well as political headwinds from populism, “Germany facing life after Angela Merkel” and the north-south policy divide.
European funds with ESG approach still in net inflows
Meanwhile, investors seem to be mainly turning away from non-environmental, social and governance (ESG) funds, while they are increasingly investing in ESG strategies.
Western European equity funds without an ESG mandate have seen outflows of -$92bn over the last year, while those that have an ESG mandate have seen inflows of +$14bn, according to EPFR Global (see chart below).
Source: EPFR Global
Rishma Moennasing, head of fund manager selection and sustainability at Rabobank Group, believes that one reason for the inflows into ESG funds is that investors increasingly integrate ESG in their portfolios, as sustainable investing is more and more becoming a standard under EU leadership.
“In Europe, we have some countries being the leaders in sustainable investing like the Nordics and also the Netherlands,” she adds.
Europe funds outperform other regions if they take an ESG approach
Research by EPFR Global has shown that, in fact, Western European equity ESG funds have outperformed other ESG equity funds in the world, returning 19.71% NAV, ahead of North American funds, with 19.26%, and similar to global equity ESG funds, with 19.62%, from January to December 2019 (see chart below).
Source: EPFR Global
Moennasing believes that the regional outperformance could come from European investors integrating ESG strategies and “probably going a step further” than other regions.
While Pereira emphasises that these are short-term trends and not indicative of what is to come in the future, he suggests that the outperformance was sector driven.
“For example, technology companies performed well over the period, many of which meet various ESG criteria. In contrast, oil and gas companies were amongst the worst performing areas of the market and generally do not score well on ESG considerations,” he notes.
Brandt however says that European ESG companies outperform other regions because of different support levels.
“The themes that ESG and SRI investors aim to reward enjoy strong government and regulatory support in Europe, which could be magnified if the fiscal stimulus packages promised to combat the impact of the pandemic prioritise SRI/ESG,” he explains.
ESG adds more alpha in Europe
Meanwhile, when comparing the performance difference of Western European equity ESG with North American and Asian funds, the Western European funds were able to outperform their non-ESG counterparts to a higher degree.
These funds returned 4.76% compared to 1.36% for North American and 1.16% for Asian funds, pointing to a possible ESG advantage of Western European funds (see chart below).
Source: EPFR Global
Pereira explains that 2019 was a strong year for European equity markets, in which they outperformed most other major equity markets, except for the US.
As the spread of their returns was “particularly pronounced over 2019”, ESG equity funds had also the largest difference in returns, compared to their non-ESG counterparts, and when compared to other regions with less business diversification.
Brandt suggests that non-ESG funds in Europe have faced relatively greater redemptions over a longer period of time, with around 12% of AUM since 1Q18 versus 3% of AUM for US equity funds over the same period.
This, he says, has forced “managers of those funds to cut deeper into their pool of better performing assets to meet those redemptions”.
“Europe SRI/ESG funds, meanwhile, are making their portfolio decisions without those redemption pressures,” he adds.
This can explain why Western European ESG equity funds have outperformed other funds in the asset class despite an overall low investor sentiment in the region.
Other factors could be the current uncertainty about how the EU will emerge from the crisis.
Brandt says that a negative response by the EU to the Covid-19 crisis is deterring investors and fund managers from building positions in Europe.
“Also, heavyweight technology plays — which have shown up well in both China and the US during the crisis – have less of a presence in Europe. In the US, tech stocks and the ESG theme intersect, giving investors an additional incentive to invest in SRI/ESG funds,” he says.
Pereira says that, given the economic backdrop, it is a little bit of a mystery why the European markets performed so well over 2019.
Considering that many ESG funds have seen inflows, “even in regions where general sentiment has been poor”, he concludes that “investors seeking ESG investments are not solely aiming to maximise financial returns, but invest in a way that is not to the detriment of the environment or society”.
