The more highly rated ESG funds also exclude companies like miners and oil and gas producers, meaning they have missed out on some of the returns on offer as commodity prices surge.
Energy boom
In particular, oil and gas companies have had a strong year, significantly outperforming the wider market.
Russia’s invasion of Ukraine sparked a period of global oil and gas shortages, when energy prices were already rising, directly benefitting the earnings of oil and gas producers.
For example, BP and Shell have reported record quarterly profits in recent months, with both their share prices recording double-digit increases so far this year.
Funds with the lowest ESG rating, which do not exclude oil and gas shares, have been increasing their exposure to fossil fuels as commodity prices surge.
While it is tempting to question the investment case for ESG funds due to their recent poor performance, investors need to be patient.
Over longer time horizons, earnings growth matters.
While a spike in oil and metals prices has occurred over the past year investors will have to work out if they expect that trend in oil and metals prices to continue over the next year.
It’s mainly short-term factors that are affecting the performance of ESG funds.
Between 2016 and 2021, a period in which oil prices were relatively stable, 57 per cent of ESG indices outperformed their non-ESG equivalents.
This demonstrates that once the energy price boom gets deflated by an increase in supply ESG funds have the potential to outperform non-ESG funds.
UK ESG funds have performed well in the past, as they benefitted from the wall of money investors were looking to allocate to equities with strong ESG credentials.
There is no reason to suggest that investors are going to drop their preference for ethical investing.
Temporary factors may weigh on short-term performance, but investors know that companies that embrace ESG can achieve better profitability than those which don’t, and make for better long-term investments.
Companies that demonstrate good ESG practices have been shown to have better top-line growth than those that don’t embed ESG into their business models.
These companies should have more supportive employees and customers and are less likely to be subject to regulatory and legal interventions, which can damage shareholder returns.
They should also demonstrate better judgement in allocating capital to promising, sustainable investment opportunities that will help drive the shift to net zero, further enhancing the return on investment for shareholders.
Jonathan Webster-Smith is chief investment officer at Bowmore Asset Management
