Are ESG funds tech strategies in disguise?

The remarkable rise of investing according to environmental, social and governance (ESG) criteria is showing no signs of slowing down anytime soon, with recent inflows into such strategies reaching $86.5 billion for the year to date.[1] ESG funds also outperformed their traditional peers during this year’s market downturn, demonstrating the ability of sustainable strategies to generate strong returns.

But the bright spotlight on ESG funds has also drawn attention to certain issues. ‘Greenwashing’, for example, is now a too-common phrase used to describe strategies that mislead investors over the environmental qualities of their underlying holdings.

More recently, ESG funds have come under fire for ‘techwashing’. It is no secret that the extraordinary performance of the US equity market has been driven by a handful of companies: Facebook, Apple, Alphabet, Amazon, Netflix and Microsoft (FAAANM).[2] The market capitalisation of the S&P 500 index has increased by $6 trillion since the start of 2015, of which these ‘super six’ contributed $4 trillion.[3]

Many ESG funds are benchmarked against the likes of the S&P 500 or MSCI World, so it is likely that they will have a high exposure to these ‘big tech’ companies. As a result, investors are raising questions over whether the success of many ESG funds is simply down to an overweight in technology.

Tech, no?

This is a concern for investors as some tech companies face big social and governance question marks: Facebook and its data-protection woes, for example, or Apple and antitrust accusations associated with its app store.

In considering these questions, we must first acknowledge the huge impact on performance that underweighting or overweighting these stocks can have. For example, Apple currently makes up 20% of the technology sector, with the technology sector itself comprising 20% of the MSCI World index. Whether these companies are rallying or not, being on the wrong side of them can have costly repercussions for performance and incur significant tracking error.

However, active investment decisions are not driven purely by market technicals and index weights. Forward-looking investment decisions require a long-term perspective, identifying well managed companies that provide essential goods and services with solid balance sheets and cashflow characteristics.

Now more than ever, we are looking to invest in sustainable growth: companies with recurring and growing revenues, and high margins which have proved resilient or have even strengthened during the global pandemic.

So while ESG funds’ target benchmarks may lead to an overweight in tech, we believe this is no excuse for neglecting the viability of a company – not only to deliver a return but to benefit the wider society in which it operates. Perhaps the perception of big tech companies will evolve throughout the crisis as they have enabled us to continue working effectively and conducting our lives in a socially distanced world.

Teams strength

It is also important to note that there are some impressive ESG performers in the tech sector. For instance, Microsoft has been tracking its carbon emissions since 2007 and achieving carbon neutrality across its operations since 2012. Furthermore, it has committed not just to being carbon negative by 2030 but to offsetting the company’s historical impact on the environment by 2050 by being carbon negative, targeting a 100% use of renewable energy by 2025. Since 2016, the company has also doubled its number of female vice presidents and increased its African American/Latino representation by 33%.

Identifying such trends is why we believe active stock selection and thorough ESG research at an individual company level is key for sustainable strategies.

We therefore welcome the ‘techwashing’ scrutiny and believe it will lead to stronger investor outcomes in the future. The lens through which fund managers determine winners from losers should be clear and transparent, and ESG considerations should be fully integrated into an investment decision rather than an afterthought.

We believe the real question investors should be asking when assessing an ESG fund is: what is the cumulative tech exposure versus the benchmark? Is the fund running a massive overweight or underweight? That will indicate whether ‘techwashing’ was the only reason for stronger performance and gives investors a clearer sense of the fund’s long-term potential.

[1] Source: Bank of America, August 2020

[2] For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

[3] Source: Gerard Minack, July 2020