Value stocks have largely outperformed growth stocks this year as the Federal Reserve turned off the money spigot. But investors have little choice if they want to buy an environmental, social or governance fund that leans towards this style.
Many ESG investors underperform the broader market for several reasons: Funds in this niche underweight sectors that dominate the market, primarily fossil fuel companies, which are considered value players due to their low valuations. ESG funds are often overweight in the technology sector, which is in a bear market.
When it comes to valuing ESG funds, their options are very limited.
Only five mutual funds and exchange-traded funds are expressly value-oriented, and four are index funds: Nuveen ESG Large-Cap Value ETF NULV,
Pimco RAFI ESG US ETF RAFE,
Calvert US Large Cap Value Responsible Index CFJAX,
and Praxis Value Index Fund MVIAX,
A fifth, Parnassus Endeavor PARWX,
is an actively managed mutual fund.
There are more than 550 sustainable funds available to U.S. investors, according to Morningstar, but the vast majority are growth-oriented strategies or are a mix of growth and value, but growth-oriented due to capitalization weighting. stock market.
The low supply of ESG value funds is unsurprising, given that the style had been out of favor for so long. Todd Rosenbluth, head of research at ETF Trends, said value ETFs have been unpopular in recent years as the Fed kept rates low, boosting tech stocks. He says the universe of ESG ETFs is still a relatively young category in terms of product development.
A cross-check of the sector holdings of the four value index funds shows that they are all underweight energy relative to their peers, with energy weighting in the large value category being around 7%. The biggest performance laggards of these funds are the Pimco and Calvert funds, which hold less than 0.5% in energy.
Abandon performance for values?
Traditional value sectors such as energy and utilities are often heavily weighted to fossil fuel companies or companies that emit high carbon emissions. When these sectors perform well, as they do today, ESG investors who avoid these types of companies may have to settle for underperformance.
Rosenbluth is quick to point out that this does not mean that these sectors will always be in favor, even in value-driven market cycles.
“There will likely be market rotation, even in the value sphere,” Rosenbluth says. “But if you own one, you might be disappointed that they don’t hold up as well in this environment because of what they lack.”
But the short-term performance drag may not matter to ESG investors.
“I think investors in ESG products should be prepared to miss out on some of the benefits, as they prioritize companies that adhere to certain standards of these three pillars of ESG. If they wanted benchmark-like performance, they could just own the traditional benchmarks,” he says.
Jordan Farris, head of ETF products at Nuveen, says the company’s ESG value fund has the most assets under management (AUM) of their total of 18 ETFs, both ESG and non-ESG. This year alone, through May 1, the ESG value fund recorded flows of $200 million.
Their suite of ESG ETFs was designed to include names that ranked in the top 50% in each sector and Nuveen overlaid a low carbon criteria to reduce the weighted average carbon emissions intensity by compared to non-ESG products. Additionally, sector weightings are optimized to be plus or minus 4% relative to the parent index to reduce tracking error. This helps ESG ETFs get relatively closer to sector representation compared to non-ESG ETFs.
Nuveen’s ESG Value ETF has a 3.8% weighting to energy and includes names such as Halliburton HAL,
and Sempra Energy SRE,
Despite this, Farris says the weighted average carbon intensity of its ESG value fund is lower than that of its peers. Morningstar calculates a carbon risk score for funds, which ranges from zero to 100, with 100 being the highest risk. It shows Nuveen’s ESG value fund carbon risk score at 7.28 against the category average of 10.28.
“I would consider this an enhancement product rather than an absolute product. What we are looking for here is a higher ESG score and lower carbon emissions intensity with a risk and return profile very similar to that of a standard non-ESG stock index,” says Farris.
Look outside the funds
Jeff Finkelman, managing director of sustainable investments at Fiduciary Trust International, said that while ESG funds are currently underperforming, it’s important to keep a long-term horizon in mind when thinking about sustainable investing. , as trends related to social issues, climate change and the inevitability of an energy transition are not going away.
Rather than looking at funds, investors may need to consider individual sectors, Finkelman says, suggesting companies in recycling, waste management, chemicals or industrial processes.
“These are the areas where ESG issues are perhaps even more material financially over time as these long-term trends play out,” he says.