I’m Bullish on ESG Investing, but are ESG Funds Getting a Failing Grade?
A Barron’s article over the weekend based, in part, on some research by Ken Pucker, a senior lecturer at the Fletcher School at Tufts University, suggests investors are not getting better results. Pucker says that ESG funds don’t systematically deliver alpha (excess return relative to a benchmark). Pucker also contends that they oversell outperformance and charge higher fees compared with plain-vanilla funds.
In a recent essay published in Institutional Investor, Pucker and co-author Andrew King, a professor at the Questrom School of Business at Boston University, discussed interviewing more than a dozen investment professionals to investigate their claims that a focus on ESG produces higher profits, signals higher stock returns, lowers capital costs, and benefits from investment flows. Pucker and King concluded, “The logic and evidence for assurances of ESG-driven alpha are lacking. Indeed, it is our best guess that flows of money into ESG funds represent a marketing-induced trend that will neither benefit the planet nor provide investors with higher returns.”
In 2022, ESG funds, being on average, overweight technology and underweight energy, are lagging significantly. Over the past decade, the results are mixed. In the decade from 2012 to 2021, all large-cap U.S. stock funds returned an annualized 14.87%, while the ESG-focused funds in that group returned 15.58%, according to data from Morningstar Direct. Both groups, however, failed to outpace the broader market, as measured by the S&P 500 index, which returned 16.55% a year during the same period. In 2022, all large-cap U.S. stock funds fell an average of 5.6% on an asset-weighted basis, according to Morningstar. The ESG funds in the group fell almost 7% in the three months ended on March 31.
Does this mean investors should not look to make a difference? To be sure, ESG managers and advocates disagree. They note that the strategy aims to deliver long-term value, and that all investment styles have stretches of underperformance. Every style and manager has a period of poor absolute and relative performance. Performance aside, the ESG lens remains a very robust framework for thinking about the overall context in which a company is operating. One question to ask is that should you be paying a higher fee for this investment lens? I would argue a hard NO! It has nothing to do with the relative performance. But the research shows thus far that there is no guarantee of excess returns and so why should you pay more. Looking at it from a lens where you care about making a difference, can this be done through investing? I would argue a hard YES! The more money available, the lower the cost of capital should be. As always, the question then becomes what sectors should be emphasized for where the economy and the trends are heading.
There are two areas of investing in our future that most should care about. Clean air and clean water. You can’t get more sustainable than that!
After reading some research recently, we came across some statistics on the use of water in the mining industry. Those that live in the GTA have probably heard the statistics about how much of Lake Ontario gets recycled by the steel industry and related pollution. Water use in the copper industry is stunning. Globally, 1.1 million tonnes of copper production is currently at risk from water scarcity problems, or about 5% of current supply capacity. Global water consumption intensity in the industry is 111 cubic metres per copper equivalent tonne. Water scarcity has to be a longer-term growth area that is key to so many industries and to health. Water based ETFs have been around for 15 years. It’s not a new theme to be sure. Returns have been about equal to global equities. There were periods of out performance and under performance.
In recent years, several more ETFs have entered the sector. Each one has a slightly different mix of sectors and focus. The sector does fall into the growth aspect of investing despite the obvious exposure to water utilities.
A much newer ESG related investment theme is decarbonization. The carbon pricing markets has been growing in recent years. The KraneShares Global Carbon Strategy ETF (KRBN) is benchmarked to IHS Markit’s Global Carbon Index, which offers broad coverage of cap-and-trade carbon allowances by tracking the most traded carbon credit futures contracts. The index introduces a new measure for hedging risk and going long the price of carbon while supporting responsible investing. To be sure, it’s a very volatile sector and it is attracting lots of money. It currently invests in the futures markets in the major European and North American cap-and-trade programs: European Union Allowances (EUA), California Carbon Allowances (CCA), the Regional Greenhouse Gas Initiative (RGGI), and United Kingdom Allowances (UKA).
Global Carbon Allowance Market Highlights
According to IHS Markit, as of December 31, 2021 the global price of carbon was $51.45 per ton of CO2. It is estimated that carbon allowance prices need to reach $147 per ton of CO2 to meet a 1.5°C global warming limit. Many argue it needs to be much higher. But I can promise, it will not be a straight ride higher.
As of December 2021, the four largest global carbon futures markets tracked by IHS Markit’s Global Carbon Index, had an annual trading volume of $683.9 billion. In April 2019, The Financial Times reported that European carbon allowances within the European Union Emissions Trading System were the world’s top-performing commodity over the past two years. In 2021, China launched its carbon allowance market, expected to be the largest in the world. Going long the price of carbon may support responsible investing and incentivize pollution reduction aligned with ESG investment goals. Can provide potential portfolio diversification due to the global carbon futures markets’ historically low correlation to other asset classes. KRBN may be appropriate for investors who are concerned about the increase in cost of carbon emissions on their portfolios. As the cost of carbon emissions rise, KRBN typically benefits and may be a beneficiary of tightening carbon emissions regulation worldwide. Please do not run out and buy these ETFs today, but they are key investment themes through the growing ESG lens for investing you should keep on your radar.
This week on our virtual roadshow webinar, we will look through the ESG investing lens and some of the longer-term investment themes that should be on your radar. Join us weekly (Thursday 7pm ET) through May 5th. Keep an eye on The Investor’s Guide to Thriving website for more information on how to sign up for notifications. The theme this year is Berman’s Call deep dives. More in-depth looks on combining fundamentals and technicals to mine for investment ideas. Should be a great series. If you have learned a few things over the years from our educational segments, please consider supporting one of my favourite charities. Dementia and Alzheimer’s research at the Baycrest Hospital/Rotman Research Institute is world class. Each year I raise money for this cause and match all BNN viewer donations. In the past 9 years we have raised almost $500,000 thanks to you. Please consider sponsoring here.
ETF Capital Management: ETFCM.com