ESG trade faces test as fossil fuel stocks rebound

Momentum trading of beaten-down oil and gas stocks in New Year challenges renewable energy theme at critical time

(Mark Hulbert, an author and longtime investment columnist, is the founder of the Hulbert Financial Digest; his Hulbert Ratings audits investment newsletter returns.)

CHAPEL HILL, N.C. (Callaway Climate Insights) — For months I’ve been warning climate-conscious investors that there would come a day when they weren’t beating fossil-fuel stocks.

That day is now upon us.

Investors in clean energy stocks therefore will soon be forced into two groups: Those who were simply fair-weather friends so long as they were beating the market, and those willing to invest in the industry even if it meant forgoing a few percentage points of return.

Take performance over the past three months. Though this length of time by no means constitutes the long term, it still is a long-enough period to start showing up in the performance scoreboards that appear on various financial websites and which capture investor attention. Fossil fuel stocks are way ahead.

The trailing 3-month return of U.S. equity ETFs that have ESG as their focus is 14.6%, according to data from ETF.com. That compares to a 49.0% gain for U.S. equity ETFs in the energy sector. (I excluded leveraged or inverse ETFs.)

To be sure, fossil fuel stocks’ rebound over the past three months is not enough to propel the sector ahead of ESG funds over the past 12 months. Over that longer time frame, the average ESG-focused U.S. equity ETF is ahead of the average energy-focused ETF by the huge margin of 24.1% to minus 18.8%. Nevertheless, once the energy sector’s more recent surge captures the attention of momentum traders, it could propel the sector even further into the lead.

That’s because momentum traders bet on the stocks and sectors that have performed the best over the recent past. Their trading becomes a self-fulfilling prophecy, as more money flowing into the stocks and sectors causes prices to rise even further, which in turn attracts even more momentum traders’ money.

This appears to already be happening. Bank of America data show that energy stocks last week experienced the second-largest inflow in nearly four years. Think about that for a second. As the presidency is assumed by someone who promises to promote clean energy, succeeding a president who actively opposed clean energy and promoted the fossil fuel industry, we’re experiencing one of the largest influxes of new money in years into fossil fuel stocks. This has the momentum traders’ fingerprints all over it.

No one knows how long this momentum-building-on-momentum scenario will continue. My point is that, even if it doesn’t last much longer, it most definitely could — and will in any case at some point in the future, too. So now is the perfect time to engage in honest self-reflection as to why you are investing in clean-energy stocks and funds.

Lower long-term returns are the key to having an impact

Perhaps the most important thing to keep in mind is that lower long-term returns are a key precondition for knowing whether you’ve had an impact on corporate behavior. If companies could produce a higher return on equity by aligning themselves with ESG principles, then there would be no point in investors trying to nudge companies to do so. In that case, profit-maximizing firms would most assuredly already be doing so on their own.

This is a subtle point. Though lower long-term returns are a necessary precondition to having an impact, they don’t guarantee that you’ve had an impact. That’s because inferior managers are more than happy to wrap themselves in the ESG flag as an excuse for bad performance. And it’s not always easy to tell the difference between a company or fund manager who is genuinely committed to ESG principles and someone who is cynically using those principles as nothing more than a marketing ploy.

A full treatment of how you might go about making that determination will have to wait for other columns and those wiser than me. The best way I can put it in the meantime is that it is not a valid reason, in and of itself, to get rid of ESG investments just because they are lagging the market.

Like many of them are now.