The ESG revolution is widening gaps between winners and losers

Fund managers find that trying to seek cheap and unloved stocks no longer pays

Robin Wigglesworth

While dedicated ESG funds remain a tiny part of the global stock market, the broader trend is towards all asset managers becoming more focused on these issues © AP

Interest in environmental, social and governance-oriented investing has soared lately. 

It now appears to be having a subtle but noticeable impact on some stock prices, widening an already big divergence between different parts of the equity market.

ESG-focused equity funds have taken in nearly $70bn of assets just over the past year, according to EPFR, while traditional equity funds have suffered almost $200bn of outflows over the same period. 

No wonder then, that asset managers seem to be engaged in a war of one-upmanship in touting their ESG credentials.

It is important to remember that while dedicated ESG funds remain a tiny part of the global stock market, the broader trend is towards all asset managers becoming more focused on these issues, whether their funds are explicitly ESG-oriented or not. 

This is now having a real impact — with potentially profound implications for frustrated “value” investors such as hedge fund managers Seth Klarman and Bill Ackman, who try to seek out unloved and cheap stocks.

What constitutes a virtuous company is woolly. Asset managers tend to define ESG, or its cousin “socially responsible investing”, differently, or weight metrics in conflicting ways. 

But look under the hood of some of the biggest ESG funds and it becomes apparent that they are heavily tilted towards tech stocks, including Microsoft and Alphabet, plus a smattering of consumer-oriented companies, such as Johnson & Johnson and Procter & Gamble. 

In the jargon of finance, ESG investing leans towards stocks classified as “growth” (fast-expanding, often racier companies) and “quality” (those with little debt and stable earnings growth).

The ESG boom might, therefore, partly explain both why growth stocks have done so well lately, and why the underperformance of value — embodied by energy stocks — has gone from extreme to record-shattering. 

“Given the unprecedented media attention focused on sustainability and its relative immaturity as an investment style, ESG is having a fast-growing impact on equity market positioning,” Barclays said in a recent report.

“We believe that it is likely contributing to widening the valuation dispersion between ‘winners’ and ‘losers’.”

The worsening outlook for value has caused anguish and frustration among many investors that have dedicated themselves to the style, which was first formulated by Benjamin Graham and most famously espoused by Warren Buffett. 

Mr Klarman of Baupost, a value-oriented hedge fund, bemoaned the environment in his latest letter to clients, but argued that the “ongoing selling pressure of value names has contributed to mispricings that represent potential opportunity for long-term investors”.

Over time, the shunning of companies that lag behind on ESG metrics may indeed lead to investors being able to harvest a “sin premium” by buying systematically underpriced stocks. 

However, given the fact that ESG-focused investing is likely to prove a secular trend, it might also mean that value will stay in a funk far longer than its proponents might like.

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