Reasons why ESG fund performance has come off the boil

Inflation is causing investors to rethink the types of companies they want to own, which is proving a headwind for ESG funds.

Despite aiming to do good and deliver market-beating performance, ethical funds returned around one-third less than their non-ethical rivals over the past year.

Financial data firm Moneyfacts calculated that the average fund that incorporated environmental, social and governance (ESG) analysis made 4%, while non-ethical peers returned just over 6% from 1 February 2021 to 1 February 2022.

The biggest gaps in performance came from funds investing in UK and global shares. Non-ethical funds made on average 14% in the UK compared with 8.5% for ethical funds.

Global stock pickers made on average 9.5% by investing without restrictions, while funds with an ethical mandate made 2.5%.

The key reasons for the differences in returns were rising commodity prices and higher inflation, which investors expected to prompt central banks to raise interest rates sooner than previously anticipated.

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Ethical funds tend to shun oil and mining stocks, which are often perceived as “dirty”. Oil stocks supply the world with fossil fuels, while mining firms can destroy the natural environment and often displace local communities to do so.

However, with the oil price rising from about $55 a barrel to $90 during the research period, and iron ore and copper also jumping in value, commodity firms were one of the best places to be invested over the past year. Shares in Shell (LSE:SHEL) and BP (LSE:BP.) rose around 50% over this period.

On the other hand, ethical funds tend to own more technology stocks due to their lower carbon footprints and the social good they often provide, such as clean energy technology, access to education resources or medical breakthroughs.

However, these stocks are normally more richly valued versus their profits because they promise to grow faster than other parts of the stock market.

In an environment when inflation is rising and central banks are hiking interest rates, investors prefer to own stocks that make a lot of money today and return it to shareholders, rather then place bets on companies that might make a lot of money in the future.

This plays into the hands of more mature and economically sensitive businesses, such as tobacco, mining and oil firms, rather than the technology stocks often favoured by ESG funds.

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Ethical funds that suffered over the research period included Baillie Gifford Positive Change, which lost around 14%, and Liontrust Sustainable Future UK Growth, which dropped about 9%.

Nevertheless, the longer-term track record for ethical funds is still impressive. Moneyfacts found that over three, five and 10 years ethical funds had beaten their non-ethical rivals.

Despite a disappointing year, investors are still buying ethical funds. The Investment Association (IA), a trade body, found that £743 million was added overall to responsible funds in January this year, despite volatile stock markets. In contrast, stock market funds more broadly saw £1.3 billion of outflows, with a net £1.6 billion withdrawal from UK funds.

Rachel Springall, finance expert at Moneyfacts, said: “Consumers may choose on principle to invest in ethical funds so it’s good to see an overall positive return over the past year. However, a return of 3.97% for ethical funds is less than the non-ethical sector of 6.06%.

“It is worth keeping in mind that ethical funds have outperformed non-ethical funds overall during previous years. Fund past performance cannot, of course, guarantee future growth, and as 2022 has already demonstrated its potential for stock market volatility, it will be interesting to see how funds will perform moving forward.”

Moneyfacts/Lipper Investment Management (IM). % Growth as at 1 February 2022, total return, UK net, no initial charges.

ESG is a minefield for investors to navigate

The variety of terms used by the fund management industry to explain ethical investing risks investors becoming disengaged from the process of finding a fund that fits in with their own values.

While the terminology can be confusing, the fundamental principle of ethical investing (or however else it is labelled or described) is supporting businesses ‘doing good’ by making a positive impact on the planet.

To help investors navigate confusing technical jargon, interactive investor launched the ii ethical long list in September 2019, which contains more than 200 socially responsible and environmental funds, investment trusts and ETFs available on our platform.

• Want to invest ethically? ii’s ACE 40 list of ethical investments can help
• The ii Ethical Growth Portfolio: a ready-made diversified ethical portfolio, selected and managed by our experts

We also launched the ACE 40, a rated list of best-in-class ethical funds for retail investors wanting to better align their investments with their personal values. All ACE 40 investments are categorised into one of three broad ethical investment ‘styles’ to help investors find a fund that meets their values. The three categories are Avoids, Considers and Embraces and you can find out more about them here.

There is also the ii Ethical Growth portfolio, which is designed to give investors an idea about how they can build their own diversified ethical portfolio.