Will we learn the right lesson from this crisis?
ESG funds have outperformed throughout the current crisis, but as I have said before, this might be simply due to luck. If you have a crisis that leads to surge demand for IT, communication services, and health care, you shouldn’t be surprised that ESG funds with their natural overweight in these sectors outperform conventional funds.
However, there is also evidence that green bonds and ESG bond funds have outperformed conventional bond funds during the crisis. And there, the sector weights diverge less between ESG funds and conventional funds. According to an analysis by Morningstar, sustainable bond funds held up much better than their conventional peers in the first quarter of 2020. And sustainable funds (both bonds and equities) continue to attract investor money while conventional funds have a hard time retaining assets.
While I remain skeptical about the outperformance of ESG funds during this crisis as a sign of better risk management, I am convinced that ESG investing is essentially about managing risks that are not priced in the market.
And if we have learned one lesson during this crisis then it is that there are massive risks that we might be aware of but that cannot be quantified properly but that can destroy performance in a heartbeat. In January I wrote about the annual Global Risk Report published by the WEF. Back then I said that the survey of global business leaders by the WEF is not worth the paper it is printed on when it comes to forecasting risks. But it is a valuable tool to assess the blind spots of risks that are not on investor’s radar screens.
I did not think I would be proven right so quickly and so dramatically. Since 2009, the risk of a pandemic or similar health event has never ranked amongst the most likely risks, only amongst the risks with the biggest impact. In essence, everyone knew this was a massive risk, but because everybody thought it would never happen, nobody prepared for it.
While ESG funds and sustainable investing cannot avoid every risk – after all, it is a risk management system and even in conventional risk management the goal is not total risk avoidance – it can help manage these unexpected risks. In other words, there will likely be more situations in the future when ESG funds will outperform conventional funds and then for the right reasons.
And if investors take the lessons of this crisis seriously, I would expect fund flows into sustainable bond and equity funds not only to continue but to accelerate. Why bother with a conventional fund if you can get an additional layer of safety with a sustainable fund?
I admit this might all be wishful thinking. After all, I am a fan of ESG investing. And there are good reasons why conventional funds may outperform going forward. The extremely low price of oil and other commodities has made fossil fuel consumption cheaper. It is entirely conceivable that this will put brakes on the transformation of our economy to a more sustainable future and may reduce growth rates for renewable energy, electric cars, and other green technologies. And if that is the case, I would expect oil & gas companies and miners to significantly outperform for the next couple of years. If you are a hardcore deep value investor, you inevitably will look at these companies right now.
Suffice it to say that I would be very worried if this happens. We are already running out of time to fight one major market risk that we will face in a decade or two: climate change. We cannot afford to lose time in the transition of our economy to a more sustainable future. We need both technological solutions to climate change like renewable energy, carbon storage, and yes, nuclear energy, and behavioural change in the shape of different consumption patterns. If ESG loses ground after this crisis we are planting the seeds for the next major crisis that will haunt the next generation of investors. And unfortunately, if that crisis were to materialise, no amount of ESG investing will be able to save us.