The bad year that many ESG investors are having may be even worse.
James Penny, chief investment officer of TAM Asset Management and a veteran of ESG investing, said the dramatic sell-off that is tearing through green stocks may soon turn into a “slow burn” that could last several years.
The green correction — with the S&P Global Clean Energy Index down more than 30% over the past year — “certainly shook up some investors within ESG performance,” Penny said in an interview. It is “certainly it was a difficult time to be invested in issues in sustainability.”
This was supposed to be the year when investors pursuing environmental and social goals would see their assets supported by historic support packages, such as the US Inflation Reduction Act. Instead, decade-high inflation and rising interest rates ended up hammering many traditional ESG stocks, with wind and solar standing out as some of the biggest losers.
For investors, the main risk now lies in sticking with the kinds of passive green strategies that exchange-traded funds offer, Penny said.
The situation to avoid in a “slow burn” is getting stuck with companies “that are constantly under pressure,” he said. There will be companies that “just can’t survive” and there will also be some that come out on top, he said.
“You don’t want to own thematic ETFs that own the entire market in that space,” Penny said. “Active management is key.”
ESG investing has struggled to regain its footing since the pandemic, when lockdowns lowered energy prices and improved portfolios that avoided fossil fuels. But when those blockades ended and economic activity roared back, the world order that followed proved toxic for many ESG strategies.
Many ESG companies are capital intensive, which makes them more vulnerable to higher borrowing costs than oil and gas companies with well-established rigs and rigs. To make matters worse, wind and solar manufacturers have been hit by project delays compounded by supply chain bottlenecks.
The best ESG funds are packed with tech stocks like Microsoft Corp. and Nvidia Corp., while some of the worst ESG strategies this year are overweight renewable energy stocks like Siemens Energy AG and Orsted A/S. Both companies have lost about half their market value this year.
Although ESG fund flows have cooled overall, ESG ETFs have continued to draw more new money than their non-ESG counterparts. Last quarter, ESG ETFs saw a 6.6% increase in flows from the previous three-month period, compared to a 3.5% decline in non-ESG ETFs, according to data compiled by Bloomberg. In the year to September, ESG ETF flows almost doubled, compared with a 20% increase in non-ESG ETFs, the data shows.
Penny, who last year correctly predicted the decline that has since engulfed green stocks, says that a key vulnerability for ESG investors is the lack of American investor commitment to the strategy.
“The U.S. market is far and away the biggest thing in the stock market,” and while the U.S. continues to pursue green limited-interest investing, “you’re not going to see that massive customer pick up,” Penny said.
Against that background, “active management, I think, will be critical, really critical, in picking tomorrow’s winners,” he said.
A few years back, ESG attracted investors who were there not just because they wanted to do good, but because they thought the strategy would deliver outsized returns, Penny said. Many of those investors have since left, which may not be a bad thing, he said.
For ESG fund managers, “It’s probably a pretty good thing that they’ve flushed out all the hot money and it’s just stuck with their dedicated capital,” according to Penny.
There is still a lot of money to be made using ESG as an investment strategy, but only if that strategy is proactive, Penny said. That could also include actively looking for greenback stocks that have fallen long enough to become potential acquisition targets.
A wave of green mergers and acquisitions is now “very, very likely,” Penny said.
“There will be some companies out there that are struggling,” but that also have “great intellectual property, great ideas and great disruptive tendencies,” he said. “You’re going to see a lot of M&A in that sector.”