Fear of ESG fund bubble due to dotcom-era valuations

As a result of the capital flows, the shares in many of these funds are trading at exorbitant price/earnings ratios that are becoming increasingly difficult to justify. One example is U.S. fuel cell manufacturer Plug Power, whose share price has climbed more than 2,000 percent since the start of 2020 – outpacing even Tesla.

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Naive investing is usually punished

“There is a risk that positions from ESG funds are now overvalued,” Chris Dyer, director of global equities at Eaton Vance, told Bloomberg. “Both active and passive investors are increasingly pursuing these issues, in some cases driving valuations to troubling levels. This kind of naive investing usually doesn’t end well.”

Selectivity as a way out

With the Nasdaq 100 Index nearly approaching dot-com-era valuations of the early 2000s, cautionary voices are being raised by Bank of America and others. After an astronomical rise in the stock prices of renewable energy providers – the poster child of ESG investing – market participants like J.P. Morgan Chase are trying to be more selective to avert the risk of a sudden setback.

Valuations of stocks with high ESG scores at record levels

The price-to-earnings ratio of the MSCI World ESG Leaders Index marched tautly northward.

ESG funds could underperform if investors pull out of overvalued stocks, particularly the technology and clean energy sectors that fueled the 2020 rally. Their relative performance may also suffer as big oil stocks, a red rag for ethically minded investors, make a comeback.

Fund Flows

Last year, a record $32.8 billion flowed into U.S. ESG ETFs and $52 billion (€43 billion) into European ones, according to data from Bloomberg Intelligence. At the end of September, total capital in sustainable funds reached an all-time high of more than $1.2 trillion, according to data from Morningstar.

E-factor has overweight

Although ESG encompasses environmental as well as social and governance issues, it’s usually the “E” that piques investors’ interest. The MSCI Global Environment Index climbed to a record high in early January, up from 93 percent in 2020, and there’s still plenty to drive capital flows into environmental funds. In the U.S., President Joe Biden has promised to increase investment in green energy and infrastructure spending. In Europe, much of the $2.2 trillion pandemic aid package is tied to green practices.

Flood of money sets alarm bells ringing

BofA strategists say clean energy ETF flows are creating potential bubbles in stocks such as EDP Renovaveis, Orsted and Verbund. The fourth-quarter rally of more than 40 percent in each of these European utilities coincided with a quadrupling of flows in the iShares Global Clean Energy ETF. 

“While we recognize that these fund flows may continue to drive stock prices higher. However, the valuations are no longer supported by our fundamental framework, and we can no longer advise investors to put new capital into them,” BofA strategists led by Peter Bisztyga wrote in a January 11th, 2021, report. They also said the flows have created a bubble in these three stocks. EDPR comes in at a P/E ratio of 50, Orsted’s is 55 and Verbund’s is 47.

Exaggerated rally

The rally in Plug Power and other fuel cell stocks prompted J.P.Morgan to lower its investment rating on FuelCell Energy to the equivalent of a sell recommendation. The bank wrote in a Jan. 14 note that the stock is “expensively valued” and recommends investors “remain flexible.”

Even though the best-performing equity fund in Europe with more than $1 billion in capital, BNP Paribas Asset Management’s Energy Transition Fund, has gained about 165 percent in the past year, some investors caution that such rallies may not last. In the U.S., stocks in the solar and hydrogen sectors have outperformed their fundamentals, says Deirdre Cooper, co-fund manager at Ninety One.

Danger of greenwashing 

ESG funds with an environmental focus also face another problem: greenwashing, when the benefits of an investment strategy are exaggerated or misrepresented. According to a survey by Schroders, pension funds and insurers with more than $25 trillion say greenwashing is the biggest barrier to sustainable investing.

Structural issue of decarbonization will remain in any case

Such concerns and valuation worries may cause some of last year’s high flyers to underperform this year. But this is far from a permanent decline in ESG funds, says Mike Chen, director of portfolio management and sustainable investing at PanAgora Asset Management. “Decarbonization is a transformation as big as the Internet was in the 1980s,” Chen said. “So this is an important structural theme that’s not going to go away, even if these funds underperform for a year.”

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