ESG gains would be few without the Magnificent Seven

This time last year, sustainable fund managers were fairly gloomy about the prospect of returns in 2023. Environmental, social and governance strategies had a bad year as the Ukraine war drove energy stocks up.

Tech stocks, which sustainable funds often hold, did not do well. The MSCI World’s ESG counterpart index had the worst relative performance to the main index since it was invented in 2007.

Fund managers I spoke to thought that the easy money was gone and they’d have to get a lot more specific, with healthcare, clean energy and water all among the sectors they were eyeing this year. 

It turns out their pessimism was misplaced. ESG funds have done surprisingly well this year, led by fresh interest in artificial intelligence, despite questions about how ESG-friendly such companies are. By November, the MSCI World ESG Leaders index had returned 20.3 per cent, outperforming the MSCI World index at 18.6 per cent. 

“It’s been much better for sustainable funds than people thought on January 1,” says Mike Fox, a manager at Royal London. 

A big reason for this outperformance is the surge in tech stocks. The so-called “Magnificent Seven” — Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla — have driven equity returns this year. By the start of this month, the S&P 500 was up 20 per cent for the year; Goldman Sachs calculated that without those seven stocks, an S&P 493 would have returned only 8 per cent. 

Investors have particularly favoured tech stocks with exposure to artificial intelligence, such as Nvidia, which is the biggest riser of the lot with an eye-watering 235 per cent gain this year. This stock tends to be favoured by ESG funds: it accounts for twice the share of the ESG-focused MSCI index as its mainstream counterpart, for example. 

“The big surprise for 2023 is the explosive investment growth for artificial intelligence,” notes Simon Clements, a fund manager at Liontrust. He says it’s been possible for sustainable investors to profit from the AI boom without necessarily buying into the Magnificent Seven. Smaller stocks, such as Cadence Design Systems and Adobe, have also done well. Jon Forster, senior portfolio manager at Impax Environmental Markets, says software company Altair, another AI play, has been one of the biggest drivers of performance for the fund this year.

A second reason for sustainable funds doing relatively well is that energy stocks have not outperformed this year, unlike in 2022. The oil price has slid amid record supply from the US and slowing demand. That said, renewable energy has not done well either. The S&P Global Clean Energy index has lost more than 30 per cent this year. 

Companies linked to increased spending on US infrastructure have also helped sustainable funds. Ferguson, the former UK company which moved its listing to New York last year, has had a good year, as have other stocks such as Trane Technologies and Comfort Systems. 

Tom Atkinson, a manager at Axa Investment Managers, saw his predictions for a strong year for US agricultural and water stocks come half true: companies like Veolia and Ecolab did well, but Deere and Trimble were weaker after crop prices fell. 

There has always been a sense that sustainable funds made excuses for investing in tech because they needed the returns. Some tech stocks are viewed as more sustainable than others

Another area of disappointment for sustainable investors was life science companies that are targeting innovation in healthcare. Stocks such as Thermo Fisher and Illumina, held by Liontrust, have not done well as growth flattened after the post-Covid boom. Clements thinks life science companies will bounce back next year, and is hopeful about electric vehicles and water stocks. 

Atkinson is less optimistic about EVs, predicting a challenging year as prices stay high relative to normal cars, with a weaker consumer. He also predicts a good year for large renewable developers as equipment prices fall. 

But the most striking thing about sustainable fund performance this year is how much it has relied on the same stocks as conventional funds. If you were overweight tech, you did well; if you weren’t then you probably didn’t.

There has always been a sense that sustainable funds made excuses for investing in tech because they needed the returns. Some tech stocks are viewed as more sustainable than others. Sustainalytics, Morningstar’s sustainable ratings arm, ranks Nvidia as low on the ESG risk scale, compared with a high rating for Amazon and Meta. Yet while AI can be used in the energy transition — to identify recyclable materials, for example — there are concerns over the threat it poses to workers and the carbon footprint of data storage. 

Some investors have been cautious for other reasons. Liontrust’s Clements has avoided Nvidia due to its link with cryptocurrencies and gambling. 

The past year may have offered sustainable funds a reprieve from the need to make more targeted investments. But they are now operating in an environment with more scrutiny from regulators and more scepticism from the public.

The reliance of sustainable funds on AI stocks raises a similar question to that posed by their broader reliance on tech stocks in recent years. Are such stocks really what sustainable investors want or are they simply what’s left after you cut out oil and gas and the more obvious contributors to climate change? 

If artificial intelligence is the future for sustainable funds, their managers need to be able to justify it. 

Alice Ross is an FT contributor. Her book, “Investing to Save the Planet”, is published by Penguin Business. X: @aliceemross