Why sustainable funds’ near-term challenges shouldn’t shake ESG believers

Despite recent ESG pain from energy prices and tech exposure, experts see a case for long-term performance

Why sustainable funds’ near-term challenges shouldn’t shake ESG believers

The momentum behind ESG funds has slowed considerably from the highs of the past couple of years, but that doesn’t mean investors will be jumping off the sustainable investing bandwagon.

Sustainable funds have swelled considerably in Canada since 2020, surging from roughly $10 billion to nearly $35 billion in assets under management based on recently available data. But more recently, Canadian sustainable fund inflows have gone from a $1.68-billion shout in the second quarter to a $243-million whisper in the third quarter, according to recent data from Morningstar.

Those recent struggles could be attributed at least in part to inflation, which for much of the year was driven by a rise in energy prices fuelled by the war between Russia and Ukraine.

This has posed a dilemma for many ESG funds that shun commodities exposure, as their strategic conviction to go all in on the world’s long-term green transition has caused them to miss out on fossil-fuel companies’ gains.

“I think in the short term, that has certainly impacted some investor behaviour and some performance of ESG funds, particularly those without fossil fuel exposure,” says Sonia LeRoy, senior wealth advisor at the LeRoy Wealth Management Group (pictured above).

LeRoy emphasizes that with any particular investment category, over or under-performance could be reasonable depending on market conditions.

“Given the many different types of ESG funds, assessing their performance as a single category can have limited relevance. So, the lack of effective framework is a challenge in effectively assessing performance,” she says. “But, I think it is fair to say those ESG funds that are more growth-oriented, and have less exposure to oil and gas, as many environment impact and themed funds are, have performed as would be reasonably expected based on their portfolio characteristics, recently under-performing, while they over-performed at the beginning of the pandemic.”

But according to LeRoy, investors who align their portfolios with their values are more likely to look past near-term performance challenges.

“I think that a lot of ESG-focused investors are coming at this with a fairly long time horizon. Also, many ESG investors are investing based on their values, caring about the positive influence their investment choices can have even beyond their own financial objectives.  So, volatility and short-term underperformance tends to worry ESG investors less. It is my experience that ESG investors are more likely to remain invested and stick to their long-term financial plans during periods of short-term volatility,” LeRoy says. “It comes down to your long-term conviction in your investment strategy.”

Responsible investors are also more likely to stick to their convictions, emphasizes Alyssa Stankiewicz, associate director of Sustainability at Morningstar, because they are looking to drive specific non-financial objectives.

“When stock markets fall, if they can connect to what they're achieving with their money, in that it's aligned with their values and helping the world move in the direction they want it to be moving, they're far less likely to succumb to fear and sell at a time when their portfolio's performing in a manner that would harm their financial plans,” she says. “At a time like now, when the stock market's volatile, it's socially responsibly invested and ESG-invested portfolios that I find, tend to stick with the program and stay invested.”

Some of the underperformance among ESG funds has also been linked to their disproportionate exposure to technology stocks, which have been largely under pressure as rising interest rates dent their long-term earnings outlooks. LeRoy says many investors were able to mitigate some of that pain by going into ESG funds that have defensive characteristics built in, such as those with dividend strategies, a more value-like style of management, or alternatives such as floating rate or infrastructure strategies.

“ESG investors, like any other investors, are looking for strategies to hedge against different possible market environments,” LeRoy says.

Advisors may also play a role in bolstering their clients’ ESG convictions. By opening up conversations about their clients’ values and educating them on possible strategies to invest according to those priorities, advisors could help drive a continued groundswell in ESG.

“Even though it's complex, we’re seeing the beginning of a new wave of awareness and adoption,” Stankiewicz says. “With advisors’ help, and with the help of regulators, I think it will become easier and easier for investors to effectively align their money with their values and achieve all of their financial objectives.”