If the value rally persists, will ESG funds lose their lustre?

Some investors suspect the value rally has further to go. If this plays out, it will be a headwind for sustainable and ethical funds.

Value shares have enjoyed a spectacular revival since the vaccine announcements last November, marking the end of a decade-long bull run for growth stocks.

Between the start of November 2020 to June this year, the S&P 500 Enhanced Value Index rose by an impressive 60.4%. This compares to a 22.9% increase by the S&P 500 Growth Index over the same period.

While this spelled good news for bargain-hunters who were brave enough to buy value shares (which tend to be cyclical businesses) late last year, it has caused a number of sustainable and ethical funds to lag their peers. This is because they tend to avoid certain value sectors, such as miners or oil and gas companies.

Value shares have paused for breath since mid-June, after the US central bank signalled that it expected to raise interest rates earlier than anticipated. Since then, concerns about rising Covid cases and inflation have also come to the fore, dampening the outlook for a strong, sustained recovery. This has caused investors to migrate back to growth companies, which are deemed more resilient during periods of lower growth.

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As we look ahead, some investors suspect the value rally has further to go. They include Matthew Quaife, head of multi-asset investment management at Fidelity International, who suggests US interest rate rises may not be terrible news for value stocks.

“Although interest rates could rise earlier than many investors anticipated, any increases are likely to be incremental. And while we are past peak growth rates, there should still be a robust economic expansion in the US this year, which should support cyclically sensitive value companies,” he says.

If the value rally persists, what is this likely to mean for sustainable and ethical funds?

John Fleetwood, director of responsible and sustainable investing at research firm Square Mile, suspects sustainable and ethical funds will lag the market over the short term, given their lack of exposure to resources and commodity stocks.

“If the value rally persists and these stocks do relatively well, then it is undoubtedly the case that sustainable and ethical funds will suffer as a result. Investors need to be aware of these compositional biases,” he explains.

Jack Turner, an investment manager at 7IM, agrees. He notes that a typical company that scores well on environmental, social and governance (ESG) criteria tends to have ‘growth’ and ‘quality’ characteristics. “These factors do not mix well with rising bond yields or booming commodities,” he says.

Turner adds: “We saw this earlier this year when the value rally was in force, from the start of February to the end of April when US Treasury yields nearly doubled from 1% to just shy of 1.8%. Many ESG funds struggled over that period and if a similar dynamic was to play out again, then we would get the same outcome.”

No time for FOMO

While this is a consideration for investors in sustainable, ESG and ethical funds, performance relative to the broader market isn’t the only factor to bear in mind. More importantly, investors should consider whether the fund still meets their objectives.

“ESG investors need pay little to no attention to market-cap benchmarks and sector averages, at least in the short term,” says Andrew Wilson, chief investment officer at Lockhart Capital Management. 

“Doing so will be unhelpful at best, as ESG funds are constructed in a different manner, and will often have greater variability of return – both for better and for worse – than whole-of-market peers and indices.”

As the fund has deliberately chosen to exclude part of the market, Wilson says it is difficult to hold the fund manager to account for the performance of that part of the market.

“The last 10 months have seen something of a resurgence in companies associated with the ‘value’ style, but this is partially as they had previously underperformed drastically. If you are worrying about not capturing the returns of this part of the market at the moment, at least be reassured that you didn’t suffer losses in the prior phase,” he points out.

However, history has shown that investors can be fickle, raising the question: if value stocks have further to go, will investors get itchy feet if the performance of ethical and sustainable funds takes a prolonged turn for the worse?

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During the first quarter of 2021, inflows into responsible investment funds remained stable but slowed in comparison to the previous quarter, falling from £3.8 billion to £2.6 billion, according to the Investment Association. It was a similar story in May, when inflows fell 21% to £1.3b billion compared with the previous month.

“I am confident that investors will not get itchy feet,” says Fleetwood. He points to his years spent working as an ethical financial adviser prior to joining Square Mile, where he saw first hand “how amazingly loyal investors are and how they stick through quite extended periods of weak performance”, such as the tech crash and financial crisis.

“These investors have a wider view and buy the funds for multiple reasons, not just financial, so are much less likely to switch investments based on financial performance alone,” he adds.

Positive long-term trends

Looking beyond the short-term headwinds for ethical and sustainable funds associated with the value rally, Fleetwood highlights the potential support on offer from long-term global trends such as the ‘low carbon transition’ and ‘the circular economy’, where companies make efforts to keep waste to a minimum.

His sentiments are echoed by Jonathan Smith, head of research at Casterbridge Wealth, who believes sustainable investments will outperform their whole-of-market peers over the long term. He says this will compensate for their lack of “short-term tactical positioning in taboo sectors such as oil, gas and tobacco”.

“While we are heavily dependent on raw materials for our transition to renewable energy, at some point in the future oil will become almost obsolete,” he adds.

Linked to this, regulation and consumer demand are likely to divert capital away from carbon-intensive and poorly governed companies in the future.

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Wilson also questions the assumption that all sustainable funds follow a “growth” style. He points to those that are willing to take positions in businesses that do not screen well for ESG characteristics with the intention of agitating for change. The hope is that this engagement can help the company to improve its behaviours and outcomes.

“This can often result in much greater ESG benefits than simply providing even more capital to a wind turbine manufacturer, for example, which has no trouble raising funds and is already sufficiently ESG-friendly. Such an approach can be agnostic to value, growth, or other metrics,” he explains.

For investors who are concerned about the potential repercussions of a value rally on sustainable and ethical funds, interactive investor’s head of funds research Dzmitry Lipski suggests looking at style-agnostic investment strategies. Here, he highlights BMO Responsible UK Income, Royal London Sustainable Leaders and Baillie Gifford Responsible Global Equity Income funds. They all feature on interactive investor’s ACE 40 list, which comprises best-in-class ethical funds, investment trusts and exchange-traded funds.

“ESG is important in these strategies, but at the same time they focus on high-quality, sustainable businesses – and you could argue that these businesses will outperform in all market conditions. The track records of these funds demonstrate this,” Lipski says.

Finally, Wilson highlights ASI UK Ethical Equity as another style agnostic strategy, which could be worth considering.