This article first appeared in The Edge Malaysia Weekly on July 17, 2023 - July 23, 2023

ESG (environmental, social and governance) funds were not spared from the overall market corrections last year caused by rapidly increasing inflation and the subsequent rise in interest rates.

To make things worse, ESG funds, many of which are underexposed to energy stocks in the oil and gas (O&G) sector, could not benefit from the increase in oil prices last year. Instead, many of them were heavily invested in the technology sector, which was hit badly by rising interest rates.

In view of these challenges, how did ESG fund returns hold up? Was the volume of investments into ESG funds — which reached a third of global assets under management in 2020, according to the Global Sustainable Investment Association — sustained?

Subsequently, it is worth questioning whether the investing case for ESG funds still exists if it is unable to outperform the market. This will likely reinforce  the sentiment that investing in ESG funds requires a performance trade-off.

Interestingly, according to data provider Morningstar, net inflows into ESG funds globally were still positive at US$157 billion last year. In the first quarter of 2023, US$29 billion (RM135 billion) flowed into global sustainable funds. Sustainable assets grew 7.5%, which exceeded the growth of the overall global fund market at 4%.

In Asia excluding Japan, net outflows of US$97 million were recorded, but Malaysia saw the second most net inflows at US$49 million.

Clearly, there is still investor interest in the asset class. But the returns have suffered, and in some categories, more than its traditional peers.

Globally, a minority (41%) of ESG funds in Morningstar’s sample outperformed their average traditional peers in 2022, and the poor performance was attributed to sector biases that underweighted the energy sector and overweighted the tech sector, which is seen as more ESG-compliant than O&G companies.

In 2022, the tech sector was the worst performing in the Morningstar Global Markets index, losing 32.2%, compared with the energy sector, which gained 34%.

As for ESG bond funds, only 21% outperformed their conventional peers. This is due to their exposure to longer-duration bonds that tend to have lower yields, which are extra sensitive to interest rate changes.

In Malaysia, the total returns (in US dollars) of a partial list of Sustainable and Responsible Investment (SRI) funds qualified by the Securities Commission Malaysia ranged from -40.23% to 13.76% in the past year (as at May 31, data available for 48 out of 64 funds) and -3.17% to 14.89% for the past two years (excluding funds not yet launched by June 1, 2020), according to Morningstar. Most of the SRI funds were launched in 2021 and 2022 (see box story).

Evidently, the returns of the funds vary widely, depending on the asset class and strategy. This means it is important for investors to understand the investment strategy of different ESG funds, without assuming that the “ESG factor” will automatically translate into better results.

“For sustainable investing to work for us, we need to understand why we invest in them and what to expect from them, especially when sustainable investing can have many forms,” says Bryan Cheung, associate director of manager research at Morningstar.

Cheung gives the example of thematic ESG equity funds that invest in electric vehicles or the energy transition. These tend to have stronger growth potential and thus come with higher risk. Additionally, Morningstar showed that its sustainable indexes with a value bias last year beat those with a growth bias.

On another note, ESG fund returns data from Morningstar and another data provider Refinitiv shows that ESG funds tend to outperform in the longer term, from three- to 10-year periods.

The weighted average success rate for an ESG fund in the most popular categories rose to 56% through a five-year period to 2022, according to Morningstar.

This would be aligned with the general view that considering ESG factors is a strategy that helps investors spot long-term risks and opportunities. Climate change impacts, after all, tend to play out in a longer-time horizon.

“While ESG funds could see temporary periods of underperformance, they have been better value generators over the medium to long term compared with non-ESG strategies. The MSCI World ESG Leaders Index and the S&P 500 ESG Index have outperformed the MSCI World Index and S&P 500 respectively [in the last seven years],” says Shahariah Shaharudin, president of Saturna Sdn Bhd, a shariah and sustainable investment firm in Malaysia.

The risks of not considering ESG factors in the long term could be harmful. This includes the increasing scrutiny and regulations on ESG issues such as carbon emissions, says Cheung.

But it is not just about financial returns. Cheung argues that it should also be about alignment with personal values and picking quality funds. This is something echoed by other fund managers.

“The prudence and repeatability of an investment approach are our key considerations, and we seek to understand its resultant expectations in different market conditions. We prefer managers who stick to their investment philosophy and process, even if prevailing market conditions are unfavourable, to managers who deviate with the intent to boost short-term performance,” he says.

Not all ESG funds are the same. Obviously, those that invest in different asset classes and geographies will have different risk and return profiles.

Based on Morningstar’s data, the Nomura Global High Conviction fund, which is a feeder fund that invests in global equities, is one of the top five performing funds in the one-, three- and five-year categories. Fund manager Leslie Yap attributes the performance to its focus on higher-quality companies, as compared with the growth tilt seen in many ESG funds.

“The target fund is driven by our ‘quality at discount valuation’ investment philosophy, which leads us to invest in higher-quality companies when they are trading at attractive valuations. As a result, we have done better than many other funds,” says Tom Wildgoose, the target fund manager. This strategy, he adds, “might be more favourable considering the possibility of companies with high ESG scores being overvalued”.

The top sectors for the fund are in information technology, consumer discretionary and healthcare, according to its latest fund factsheet (May 2023).

“Very recently, tech has done better as people have focused on the opportunities in artificial intelligence,” says Wildgoose. But the tech sector is rife with ESG controversies such as data security, high energy usage, monopoly and tax avoidance. How do they justify investing in the sector?

Wildgoose says they look at the company’s impact on a wide range of stakeholders and, through the process, objectively assess the severity of the issues. “It has caused us to avoid some of the worst ESG controversies, particularly in the area of data privacy.”

Nomura has identified six impact goals as a guiding framework to engage with companies. These goals contribute to long-term targets like mitigation of climate change, elimination of communicable diseases and ensuring global access to clean drinking water.

“Large holdings such as Microsoft are interesting in that their scale allows them to encourage the investment in low-carbon power generation to mitigate climate change. In fact, it has committed to becoming net neutral on carbon emissions on a cumulative basis, which means eliminating carbon emissions it has made,” says Wildgoose.

“Other companies contribute to other goals. For example, Novo Nordisk’s diabetes and weight-loss drugs are helping to mitigate the obesity epidemic.”

Wildgoose sees responsible investing as “the right thing to do”. “We don’t believe that investors have to sacrifice financial returns when investing in ESG funds. Therefore, we focus on the other reasons to incorporate ESG into the investment process, such as maintaining low carbon emissions or having a positive impact on the world.”

A top-performing fund in the three- and five-year periods is the ICD Global Sustainable Fund by Saturna, which has a bottom-up, medium- to long-term strategy that only invests in companies that are ESG and shariah compliant. It uses an in-house proprietary grading system that assesses companies’ ESG disclosures and information from third-party data providers.

The main characteristics of its sustainable rating system include resource efficiency under the environmental category, business ethics and products under social, and board effectiveness and conflict assessment under governance.

Of course, secular growth drivers and management execution track record, among other conventional investing indicators, are considered.

This means sector allocation is secondary, says Shahariah. “While this could result in short-term periods of underperformance, we believe that over the medium to long term, we have a good chance of generating solid levels of performance if our different investment theses crystallise.”

Subsequently, there are no “ESG sectors”. It depends on individual companies and how they are ESG-compliant.

“For example, several of our peers invest in energy listings, which they perceive to be ESG-compliant even though the energy sector itself is not,” says Shahariah.

The returns for the fund were driven by the strong performance of the healthcare sector. 

Interestingly, “our strict ESG focus has also paid off this year as we have no exposure to the energy sector, which has been weak. The consumer staples sector has done well, particularly L’Oreal and Church & Dwight, which makes household and personal care products, as has communication services, with Alphabet Inc being a key performance driver”, says Shahariah.

The fund’s top sector allocations, according to its latest fund factsheet (May 2023), are in healthcare (23.2%), technology (22.4%) and consumer discretionary (12.9%).

When asked about the controversies in the tech sector and in its holdings in companies like Johnson & Johnson, which is facing over 40,000 lawsuits claiming its talc products caused cancer, Shahariah says these issues are monitored and discussed in their investment committee meetings before actions like divestment are taken.

“There have been instances where we have not invested in otherwise attractive tech companies due to privacy and data security concerns around those companies,” she says.

Saturna’s Asean Equity Fund has also performed well. The investment strategy is the same, with the only difference being geographic exposure. This poses a challenge to Saturna, since the universe of Asean companies that meet its ESG and Islamic criteria is smaller.

Regardless, the growing number of guidelines around ESG disclosures in the region is increasing, says Shahariah. Sell-side houses have begun to incorporate ESG concepts into their research and stock evaluations, and ESG ratings will increasingly be given to domestic and regional companies.

This will drive the development of sustainable investing. As sectors generally considered to be non-ESG compliant, like O&G, are transitioning into sectors like renewable energy, “it is not inconceivable that ESG investing could over time become the pre-eminent, if not the only, investment strategy”, she says.

Two of the first digital investment managers in Malaysia to offer responsible investing (RI) or ESG portfolios are StashAway and Mytheo.

The reception from investors has been positive. Ronnie Tan, CEO and managing director of Mytheo, shares that its ESG portfolio saw more inflows than outflows last year. Launched in October 2021, the ESG portfolio recorded a year-to-date performance of 7.81% (as at end-April 2023), outperforming its other portfolios such as growth (6.25%) and income (4.98%).

Tan says this is because ESG is more prevalent in developed markets, which have performed well.

Mytheo invests in exchange-traded funds (ETFs) that follow indices from MSCI, which has an ESG framework that scores companies on climate change, governance and controversies. These ETFs, of course, have to also meet Mytheo’s liquidity requirements and achieve regional diversification.

Tan’s view is that ESG-compliant companies that are true to spirit should be more resilient against business failures and more robust during market crises, but one should not “mistake that for immunity”, he says.

Two risks that investors of ESG portfolios must consider: Greenwashing and concentration risk. 

ESG funds will only grow when there is better education on what they are, and strong regulations around ESG, he adds.

Meanwhile, StashAway’s RI and Environment and Cleantech Thematic Portfolios, which were introduced in January 2022, represented around 10% of its net inflows in the past 12 months. However, this is still less than 5% of its total assets under management, says country manager Wong Wai Ken, who observes that investors are still cautious at this time.

Since inception, its RI portfolio returns have ranged from -2.9% to 2.8%, depending on its risk levels. It outperformed same-risk benchmarks by 1.2 percentage points from mid-January 2022 to end-May 2023.

The thematic portfolios are considered more high risk. “That said, during a period where global stock and bond indexes were down about 10% or more, our [thematic] portfolios’ average returns of 2.1% illustrate the promise of this theme,” says Wong. 

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