Stakeholder capitalism, the idea that a public company’s focus shouldn’t only be on shareholder profit generation without addressing the larger picture, and a theme accelerated due to COVID-19, has catapulted socially conscious investments to the forefront of most investment managers portfolios.
Since standardized evaluation criteria within the investment community is still lacking, the key to evaluating an investor’s ESG performance requires a deep-dive into the stocks in which these funds are actually investing.
ESG funds have progressed since their introduction, and stock selection has transitioned from solely exclusion-based, to positive ESG stories. Fund performance has largely improved throughout this transition. In fact, it’s been well reported of late that ESG funds are tending to either match or even exceed the performance of non-ESG funds. So, what’s driving this trend?
The Q2 2020 Global Fund Insights Report by Refinitiv Lipper’s Head of Research Robert Jenkins, aims to provide a high-level overview of what some of the more prominent ESG funds are investing in. Below we highlight his most interesting findings.
Examining the holdings
Jenkins examined 12 funds from a list of nine fund families within the large-cap, U.S. orientated fund space. This space holds some of the largest and most well-known funds, and these 12 funds collectively hold $33 billion in AUM.
Most notably, Jenkins found that he top 10 names across these funds carried a lot of weight – on average more than 40% of these funds’ investments were housed in their top 10 holdings. Although at first glance this may seem highly risky, since any movement in those top 10 holdings would greatly affect the performance of the fund, this is pretty common practice for active management, who often use a conviction-based approach and bet big on plays they have confidence in.
Perhaps another reason for the heavily weighted top 10 holdings, is the domination of well-know tech names. The list on the left, a composite list of what the typical top 10 holdings of a U.S. large-cap actively managed fund would look like based on the frequency of the stock names across the sample set and their relative weightings, demonstrates this. The presence of high-flying tech stocks like Microsoft and the FAANGs does lead to the question of how these so-called ESG funds differentiate based on ESG criteria, since a large portion of their investments seem to follow their non-ESG counterparts, and the S&P 500, as we will see below.
However, there is a simple, and likely reason for all this tech : they tend to not be known as carbon emitters, so they seem like safe bets to front up an ESG portfolio and, if your investment goal is focused on climate, this may be just what you’re looking for. To that, it helps that these same stocks have been on a years-long bull run and are thoroughly outpacing market averages and most typical stocks.
Active sector allocation trends
Looking now at how the active managers allocated across sectors for some additional clues about what makes these funds tick, Jenkins found a lot of similarities to the broader market with a couple of glaring exceptions. Below are charts representing the composite of the funds sector allocations compared with the S&P 500.
One sector the active managers have clearly been actively banishing from their portfolios over the past few years is all things energy. In fact, only one of the 12 funds had any allocations to the energy sector, and that one fund had less than 2% worth of energy holdings. Renewable energies have not substituted their “dirty” predecessors in terms of market size nor investment opportunities as of yet, so active fund managers prefer to steer clear of the sector for now.
Beyond just energy, ESG funds tend to be lighter on utilities (with about half of the funds examined not holding any utility stocks), communications, financial and consumer staples stocks. Not surprising, since many of these sectors are ressource and infrastructure intensive, and not very conducive to sustainability.
How does passive compare to active?
Unlike active funds, passive funds maintained an exposure to the energy sector. In many instances, it’s a very similar level of exposure that we would also find in the S&P 500. Collectively, these funds represent just shy of $30 billion in AUM across passive funds and ETF products. Because many of these funds have a cap-weighted index orientation, the top holdings tend to cascade in line with their cap sizes so the composite weight of the top 10 was 27% as compared to 40% for active. While Jenkins said we might expect there to be at least some differences in what active and passive managers hold at the top of their lists, the following table shows there isn’t.
New favorites apparently not as appreciated by active managers include the likes of Procter & Gamble and Johnson & Johnson, both of which are large, multi-faceted organizations with operations involving manufacturing, chemicals, packaging and ultimately shipping, to name just a few relevant aspects of their businesses. Because of all these considerations, we can see that a substantial analytical exercise is required to develop a material ESG perspective on organizations such as these.
Passive sector allocation trends
Unlike active funds, passive funds maintained an exposure to the energy sector. In many instances, it’s a very similar level of exposure that one would also find in the S&P 500. In fact, the differences in sector weightings across the board are remarkably unremarkable, nearly mirroring the S&P 500, says Jenkins. Passive and index products are often built with an eye toward delivering a market-like return under the ESG label, so Jenkins says the close mirroring of the market in terms of sector weightings shouldn’t surprise.