Calastone, the funds group that monitors investment flows around the world, said June was the worst month ever for outflows in so-called ESG (environment, social and governance) funds.
In Australia, where ESG is still classified by Calastone as “a small relatively new asset class”, more than half a billion dollars went out the door in the three months to June.
After having a golden decade where the money rolled in and few questions were asked, ESG is now facing a perfect storm.
In recent months the general trend across investment markets is a swing away from shares and towards the safety of bonds and cash, but ESG has often been impervious to broader market cycles. Not any more.
Politically, ESG is getting hit hard from all sides.
On the right of politics, US Republican states have led a strong campaign against ESG as it currently operates. Florida in particular has created a new legislative framework which limits government and corporate activism in ESG investing.
Florida governor and Republican presidential hopeful Ron DeSantis is now demanding that all investing done on behalf of the state’s taxpayers is prudent and “does not include the furtherance of ideological interests”. This US law will, by definition, reduce the amount of money flowing into ESG investments.
On the other side of Atlantic, European Union leaders – politically miles away from US Republicans – are pressing for more accurate and transparent ESG regulations.
In effect, both sides of politics are trying to achieve the same thing, a more honest and effective version of ESG than we have just now. But the political heat represents a pincer movement against ESG at a time when investors are returning to conservative investments with rising rates and the threat of a global recession.
As Alex Dunnin at Rainmaker sayss: “The serious players who want to last the distance are toughening up. It’s not just about a few cliched divestments here and there. This should see a bit of a shake-out down the track.”
Bandwagon’s bust
The outstanding problem for ESG is the hijacking of the entire sector by those who simply jump on the bandwagon to get both the money in the door and the scores on the board.
Examples are too numerous to mention, but it’s hard to beat this year’s ESG ratings from the highly regarded S&P Global group which hit the headlines for all the wrong reason in assessing the electric car maker Tesla.
Guess what? The Chevron oil company ranked higher than Tesla when it came to the E (environment) score.
But that was not the top prize for double standards. In the G (governance) category, cigarette maker Philip Morris came out on top of Tesla for disclosure.
In everyday business big companies manage ESG just like any other issue. An oil company can improve its ratings by offloading dirtier assets to private companies who don’t even try to score on the ESG spectrum.
It this sort of box-ticking that has even the most earnest ESG investors worried.
Separately, investors who may have been assured in the past by seeing the biggest names in finance staunchly defend both the aspirations of ESG investing and the need to follow its core themes are now changing the script.
The world’s most famous ESG advocate has been Larry Fink, head of the world’s biggest investment house Blackrock.
In recent weeks Fink has banned the term ESG. His explanation is that the term has been corrupted by politicians on the Left and Right. This is what Fink said: “I’m not going to use the word ESG any longer because it’s been misused by the far Left and the far Right. Instead we will talk about decarbonisation or we will talk about government or social issues.” But the end result is that Blackrock no longer supports ESG as we know it.
The shake-out
The deeper problem for investors regardless of politics is that ESG has recently failed to bring in the strong returns that a new generation of investors might have believed would run forever.
Whatever way you cut it ESG is a thematic – in creating exclusions it means investors will have more volatile returns than a fund that simply invests for the best return.
Last year as oil, gas and coal prices surged, ESG investing ran stone cold – many sustainable funds saw returns twice as bad as the 4.8 per cent drop for average balanced funds in 2022.
We don’t know how the full year 2023 will turn out for ESG, as green investments may rebound, but the thing is that for now money is flowing out with a vengeance.
Calastone says Australia ESG equity funds have “now seen consecutive outflows for five months, having only shed capital in two months in the previous two years”.
For investors the problem is that ESG actually matters a lot. Sure, the area has been gamed for years. But the catcall of “go woke, go broke” is meaningless. Woke wins and woke loses depending on the mood of the market.
For example, anyone who steered away from the big tech stocks this year in favour of energy stocks missed a major opportunity. Those ESG-friendly “magnificent seven” stocks been responsible for 80 per cent of the sharemarket lift this year. (see today’s feature in Wealth by Chris Demasi).
On the other hand putting Chevron and Philip Morris higher on the ESG scale than an electric car maker makes a joke of the entire ESG enterprise.
Still, if we carve it up, ESG factors are genuinely material in how investments perform. Environmental disasters can drag on mining companies for years. Bank stocks would pay higher dividends if they did not constantly get fined for poor governance.
As Hortense Bioy, Morningstar’s global director of sustainability research, has pointed out: demand for more stringent ESG funds remains strong worldwide.
ESG as we know it – a rubbery concept wide open to attack from both sceptics and true believers – is finished. A shake-out is up and running. By the time it’s over, the survivors will be ESG players we can depend on. And that would be a win for every investor.
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