ESG investing might be over-inflating certain stocks, but the trend is diversified, and backed by more than just financial speculation.
As money continues to flow unabated into ESG labelled funds, there is a burning question percolating within the financial sector. Is ESG a Bubble?
The idea that ESG might be a bubble, reminiscent of the .com bubble in the late 90s, stems from the staggering amount of capital flowing in ESG-labelled products. In 2020 alone, according to Morningstar data, $326 billion flowed into ESG-labelled funds, more than double the $154 billion from the previous year. In total, ESG funds have now reached $1.7 trillion.
This exponential growth has led many analysts and commentators to speculate that the ESG market is overheating, and no longer reflective of the financial performance of the companies within these funds. In other words, a bubble waiting to burst.
How is the hype in tech stocks related to ESG investing? It gets a little murky here.
It has to do with the fuzziness around what being an ‘ESG fund’ actually is. Until recently, there has been little regulation about what qualifies a fund to label itself ‘ESG’. Look under the hood of BlackRock’s ACS World ESG Equity Tracker Fund, as Investors’ Chronicle did recently, and you will see its top six holdings are Apple, Microsoft, Amazon, Facebook, Google and Alphabet, all of which qualify as ‘low carbon companies’. In this sense, some of the current ESG boom can just be seen as a tributary of the tech boom.
To further illustrate this ‘fuzziness’, according to Morningstar, in the final three months of 2020 at least 219 funds rebranded as ‘ESG’ or similar, often without any change to investment strategy. Many ‘ESG’ funds are simple wolves in sheep’s clothing.
Ironically, the fact that ‘ESG’ funds are so subjective, often based on different ratings methodologies, can actually prevent a bubble occurring in the short-term, as there is a huge diversity of companies which, according to one methodology or another, can be considered to be ‘ESG’. This, in its own peculiar way, prevents the widespread concentration of capital.
While some of the influx can be explained by the tech-boom with a green twist, where this influx of capital does risk creating a genuine ESG bubble is by inflating the stock prices of a select few stocks which are overrepresented across ESG funds, especially in renewables and fuel cell companies, leading to outsized value to earnings ratios.
EDP Renovaveis SA is trading at 50 times earnings, Ørsted at 55 times earnings, and Verbund AG at 47 times earnings. This led Peter Bisztyga, an analyst at BofA, to stop advising investors to invest in them, arguing that these flows have “created a bubble in these three stocks”.
So yes, in a few select stocks, the desire to be part of a trend may be outweighing the soundness of conventional financial analysis. And ESG strategies are funnelling substantial amounts of capital into companies with high ESG-ratings.
In essence, sustainable investing is about directing capital towards companies and projects through decisions that take into account more than just financial performance. This factor is likely to distort valuations.
As a trend, however, ESG investing is driven by the increasing willingness of professional and private investors to consider environmental and social outcomes as valuable return on investment, why at least some portion of the ESG-exposed investors today, are unlikely to just leave the most impactful and responsible companies behind when valuations get too steep. But they might have to settle for lower performance from their favourites for the time to come. As a recent Barclays report said, “Like any exciting investing idea, expectations can exceed reality for a time. It’s likely that this is the stage of the cycle for sustainable investing.”
Head of Multi-Asset Portfolio management at Natixis, James Beaumont argues that, going forward “rather than blindly chasing ESG exposure, we expect investors to become increasingly discerning in the ESG exposure they wish to take”.
As the initial ESG-froth settles, increased regulation (the EU’s SFDR is clamping down on ESG fund labelling, for instance) and improved data quality will begin to reveal which companies are genuinely outperformers or laggards on a more granular range of ESG metrics. This could separate investors who are chasing ESG funds because they outperform the market and serve as good PR, and those who genuinely understand and are discerning about the social and environmental impact they enable through their investments.
There is a chance that this will mean the wild figures we are hearing of ‘$1.7 trillion invested in ESG funds’ will indeed go down. This doesn’t mean that the ESG bubble is bursting. On the contrary, it will be necessary if ESG is to become what it claims to be - a genuinely transformative force for moving capital towards companies which serve people and planet.