Why are esg funds underperforming?

How are ESG focused indices different from traditional indices

ESG indices take the same universe of companies as a traditional index but make rules-based systematic adjustments.
For example, a set of ESG index rules might exclude companies with exposure to alcohol, tobacco, fossil fuels, weapons manufacturing, and adult entertainment.  Furthermore, the rules might adjust the weighting of the company based on its ESG score.

Why are ESG indices important?

ESG indices are used by ESG-focused index tracking funds and ETFs.
By comparing the performance of ESG focused indices and traditional indices we can see whether or not the ESG focus positively or negatively impacted performnace relative to traditional equity indices.
Whilst pre-2022 some have argued for an ESG premium over the long-run (good companies should be well rewarded via a lower risk premium), since 2022 the hard reality of ESG relative underperformance compared to traditional equities is a reminder that any such premium is indeed "long-run", and in the meantime, short- and medium-term performance differentials matters too.

What are the main differences between ESG focused indices and traditional indices?

Whilst methodologies will vary from index to index, at a high level the key difference of ESG indices and funds to traditional indices and funds is:

1. ESG indices/funds hold more technology companies
   
2. ESG indices/funds hold less or no fossil fuel energy
   
3. ESG indices have a lower allocation to value-oriented sectors such as materials and commodities producers

When did ESG performance shine?

The Covid era seemed like a golden era for ESG funds and they received record inflows.  ESG focused world equity indices slightly outperformed their parent indices in 2020 at a time when the world stood still and the oil price briefly went negative.  Investors could get similar or better returns, and have a clearer conscience.

What changed in 2022?

A combination of pent-up demand, monetary supply and then the Russia-Ukraine war and related sanctions and energy crisis marked the return of inflation.  ESG focused funds excluded fossil fuels and materials and so did not hold "inflation protective" sectors that traditional equity indices continued to hold.  We explored this further in our published inflation-related research at the time.

Why were ESG funds less resilient to the inflation shock?

Ironically, the exposures that do best in an energy shock and a higher inflation era, such as energy, materials, and commodities are the sectors that were excluded or low-weighted in ESG focused indices/funds.  Similarly following the Russia/Ukraine war and heightened geopolitical risks, the defence sector has performed very strongly: this is part of traditional indices but not part of ESG indices.

What is the difference for ESG indices pre and post Covid?

In summary, ESG indices fared similarly to traditional indices pre-Covid, fared slightly better than traditional indices during Covid, and have fared worse than traditional indices since Covid.  We are now living in a higher inflation era, with changing energy supply chains and an era of geopolitical insecurity.  Furthermore with the new US Presidential administration under Donald Trump being pro-oil and less generous to clean energy, these trends could continue.

How should advisers navigate clients' ESG preferences

Increasingly advisers want or need to take clients' ESG preferences into account.  Some clients may have a ESG preference, so long as returns are not compromised.  Other clients may have a ESG preference as a priority over returns.  Having an informed discussion about the differences between traditional and ESG investing can help explore these preferences in a more informed context.

ESG is struggling in a world of energy supply changes and increased defence spending

The chart below shows the performance lag between a Socially Responsible world equity ETF and a traditional world equity ETF.  The ESG-focused Socially Responsible ETF started materaily underperfomring from December 2021, just before the Russia-Ukraine war and related sanctions disrupted energy supply chains and forced the US and Europe to rethink their need for defence spending.

See all our ESG-related published research