One year after the Inflation Reduction Act (IRA), the White House claims the initiative has catalyzed $110 billion in clean energy projects, putting the U.S. on track to achieve 80% clean electricity and cut emissions by 41% by 2030. Impressive, right? Surprisingly, climate-focused funds are underperforming, showing a negative 13% return versus the S&P 500's +17%. That’s a staggering 30% performance differential.
The Disconnect: Unpacking Underperformance
After reviewing fund manager reports, it becomes evident that a larger issue looms beyond the commonly cited high interest rates and currency fluctuations. The crux of the problem? Crowded trades. Essentially, 15 major climate-focused funds are largely betting on the same companies, thanks to backward-looking indices and similar investment screens.
Backward-looking indices + Similar screens = Crowded trades
How did the crowded trades arise? It starts with the underlying benchmark indices whose construction methodology uses backward-looking screens and opaque ESG scores. Then, fund managers apply similar screens resulting in a further convergence towards a limited list of investment opportunities. Pull up the holdings of a typical low-carbon or climate change fund and, instead of seeing a list of climate change-makers, large-cap tech, and software companies dominate the top holdings.
Fund performance matters
The investment underperformance hasn't gone unnoticed. Morningstar reports a significant slowdown in ESG fund inflows over the past six quarters, with the U.S. even experiencing outflows due to political factors.
The Recipe for Successful ESG Investing
To achieve both financial returns and meaningful impact, successful ESG investors embrace the mindset that ESG is a source of alpha, not a check-the-box risk exercise. They tend to do three things well.
1. Relentless focus on investment materiality
A characteristic of successful ESG integration is the ability to identify the two or three critical ESG factors that impact a company’s cash flows and/or its ability to access capital. For instance, data privacy and cybersecurity are critical for software companies, while ecological impact and safety are key for pipeline businesses.
Frameworks such as SASB are a useful starting guide. Tools like Portageur accelerate the ESG analytics process by analyzing thousands of documents with an investment materiality mindset.
Identifying the critical ESG factors requires common sense business understanding, curiosity, and some digging around. The reward is clarity. Deeply understand the 2 or 3 issues that matter, instead of researching 100 issues that don’t move the needle.
2. Quantitatively testing the qualitative hypothesis
It's vital to quantitatively assess how identified ESG factors contribute to long-term value. It expedites the traditionally slow research process and makes investment materiality come to life. For instance, DE&I statistically creates value for the financial sector but has less impact on other sectors.
The issue is that ESG analysts need this type of quantitative analysis but it may take months to get a basic answer. It’s tedious work to scrub, normalize, apply algorithms, and benchmark vast amounts of ESG data. Analytic toolkits like PortageBay strive to make such analysis quick & painless.
3. Trust but verify
Crowded trades often occur when everyone relies on the same data to reach a similar conclusion. Moreover, the problem worsens when you rely on voluntary corporate ESG disclosure because you’re only seeing what the corporations want you to see.
To level up to the ESG alpha mindset, experienced ESG investors incorporate alternative data. “Trust, but verify” a company’s progress with a 360-degree view of information. For instance, you would have predicted that BP would roll back its emissions targets, identified which companies have a higher risk of oil spills, and which CEOs would be ousted. Alternative data provides this value-added information edge.
Next steps
To avoid the pitfalls of crowded trades and outdated data, successful ESG investing must marry the depth of fundamental analysis with the scalability of quantitative modeling. ESG contributes to alpha even further when incorporating alternative information sources.
If that sounds daunting, tools like PortageBay offer an additive, efficient way to refine your ESG investing processes to achieve both stellar returns and meaningful impact.
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