ESG investing can be volatile — but doesn't have to be

Fans of ESG, who might have enjoyed the impressive triple-digit gains of select strategies last year, could be experiencing a bit of a hangover in 2021 if they didn’t navigate through another trend: value overtaking growth stocks.

Looking at 10 of the best-performing environmental, social and governance funds last year, as tracked by Morningstar, it would be easy to assume the ESG space had suddenly lost its mojo.

Consider, for example, the 234% gain last year by Invesco Solar ETF (TAN), which is down 23% so far this year.

Other hot funds last year included the FirstTrust Nasdaq Clean Entergy ETF (QCLN), which gained 184% last year and is down 10.2% this year, and the iShares Global Clean Energy ETF (ICLIN) gained 141% last year only to fall more than 19% this year.

The S&P 500 Index, by comparison, gained 16.3% in 2020 and is up 12% so far this year.

Todd Rosenbluth, director of mutual fund and ETF research at CFRA, attributes the stunning turnaround for certain ESG strategies more to the trend toward value than anything else, and adds that it is a reminder that all ESG strategies are not created equal.

In essence, the ESG funds that topped the charts in 2020 were narrowly focused bets, many of which enjoyed a boost from limited exposure to traditional fossil fuels, which suffered last year.

“Clean energy investments declined in value in recent months as investors rotated toward more value-oriented securities and away from long-term growth ones on expectations of higher interest rates,” Rosenbluth said. “While the long-term trend toward clean energy remains, there’s been higher than expected volatility in recent months.”

Meanwhile, investors who moved out of or avoided the more concentrated ESG exposures have enjoyed a less-exhilarating, but much smoother ride with broader ESG exposure.

For example, the iShares MSCI KLD 400 Social ETF (DSI) gained a respectable 20.9% last year and is up 13.5% this year, which combine to beat the S&P 500 by 6.1 percentage points.

Other examples of quieter, but still impressive, broad ESG exposure include FlexShares Stoxx ESG Impact ETF (ESGV), which gained 20.8% last year and is up 12.5% this year, and iShares ESG Aware MSCI USA ETF (ESGU), which gained 22.5% last year and is up 12.3% this year.

Tom Roseen, head of research services at Refinitiv Lipper, said some of the more popular asset classes last year have been hit by the rising threat of concerns over inflation and rising interest rates down the road.

“After the strong runup in alternative energy funds, which gained 91.61% in 2020, investors took some of their hard-won profits off the table as they began to worry about how higher interest rates and supply-related inflationary pressures were going to impact the economy and lower returns for renewable energy projects,” he said.

Meanwhile, since the start of the year the average alternative energy fund has lost 3.65%, which includes 2020’s leader in this space, the previously mentioned Invesco Solar ETF.

If nothing else, the starkly contrasting performance within the ESG space is a reminder that diversification usually makes sense.

“ESG investors are investing for conscience and to make a commitment, and many ESG investments have a premium for that privilege,” said Leon LaBrecque, chief growth officer at Sequoia Financial Group.

“If solar was more efficient and economically viable than oil, it would outperform oil,” he added. “ESG investors should acknowledge that they are removing some components of returns from their investments. My wife and I have half our donor-advised funds in ESG and half in regular indexes. So, we feel good about making money and feel good about our investments as well. If defense stocks pay for good things, I'm OK with that.”