Few phrases unsettle investors more than “market bubble.” It comes when a type of asset has attracted so much attention and demand that its price is pushed far beyond a reasonable valuation, putting it at heightened risk of bursting from its overinflated state.

The exponential growth of ESG has also invited murmurs of a bubble—24% of all new fund investments through the first quarter of 2021 were directed toward those with ESG ties. However, the world’s largest financial firms have not found a firm stance on whether a bubble is realistic. In August, JPMorgan Chase strategist David Stubbs declared that ESG was not on the verge of bubble status. Yet, 20 months earlier, the firm’s chief US equity strategist, Dubravko Lakos-Bujas, called ESG “a bubble in the making.”

For the sustainability-minded investor, hearing out both sides of the debate is a valuable exercise in understanding how exuberant market dynamics can detach from underlying philosophies.

Addressing Fears of a Bubble

Perhaps one of the biggest yellow flags around ESG investing surfaced earlier this year in Japan. Although the massive Government Pension Investment Fund has allocated about $40 billion to ESG-themed funds since 2017, in April 2021 a senior director with the organization publicly questioned sacrificing returns while emphasizing ESG investments. Chris Dyer, director of global equity at Eaton Vance, likewise warned Bloomberg in January that “this type of naïve investing tends to end badly.” His rationale stemmed from soaring valuations among select renewable energy companies.

A handful of ESG-related stocks even got caught up in the GameStop-fueled meme stock mania that swept through the markets in January and February. A Bank of America analyst team cautioned that the surge of investor interest left the asset class susceptible to a sharp fall.

Thoughtful consideration of rapid and robust investment returns could lead some to conclude that ESG investors have gotten ahead of themselves. As Stephen Beer of the Church Investors Group wrote in the Financial Times in August, “unless a business is sustainable financially it will not be around to exercise responsibility.” He added that if ESG funds achieve their investment objectives—including financial return expectations adjusted for ESG factors—then they have met investor mandates. However, a red-hot asset class can distort any or all of those measures.

Bubbles thrive on momentum, and abundant positive sentiment can help fuel an unsustainable rise.

Tracing Positive ESG Outlooks

One of the biggest issues in supporting an increasingly popular asset class such as ESG investments is walking the fine line between believing in its growth potential and taking a stance that feels like promotion. Bubbles thrive on momentum, and abundant positive sentiment can help fuel an unsustainable rise.

Pointing to the intermittent crescendos in the renewable energy space and electric vehicles, Mike Chen of PanAgora Asset Management told Bloomberg that this can lead to pockets of outperformance and underperformance. However, overall he says the macrotrend of decarbonization supports ESG investing for the long haul.

Furthermore, a CoreData survey of large institutional investors found that 63% of the 200 investment professionals polled expect that all funds will incorporate ESG elements by 2026. Although a significant majority acknowledged worries about greenwashing by fund managers looking to capitalize on ESG investing trends, 72% rejected the proposition that ESG investments are in a bubble set to burst.

Bridgewater Associates Co-Chief Investment Officer Karen Karniol-Tambour points out in a Financial Times article that most common ESG indices show valuation characteristics similar to the broad market, and that the valuation of ESG stocks is nearly the same as a global equity portfolio. “The US ESG index looks very similar to the aggregate market,” she writes. “And much less frothy than stocks that have been most popular with retail investors.” She also notes the gradual nature of the shift to sustainability has been gradual, keeping ESG stocks aligned with the market—at least until recently.

Looking Ahead to Protect Portfolios

Regardless of whether you consider the ESG market as a glass half full or overflowing, buffering your sustainable portfolio from extreme moves is prudent. Expert advice on that front includes:

  • Diversify across ESG issues, encourages Nikesh Patel, head of investment strategy at Kempen. A portfolio largely focused on sustainable energy investments might benefit from a balance of other impact investments.
  • Monitor performance and selectively rotate into more obscure corners of the ESG market, says John Leiper, chief investment officer at Tavistock. There will always be sectors, industries, or stocks that rise to valuations beyond realistic growth expectations. At that point, consider shifting some of the portfolio to a solid ESG investment that is out of the spotlight.
  • Dial up your skepticism, recommends Tim Crockford, senior fund manager at Regnan. Investment companies have opportunistically created new funds or ETFs or altered the investment philosophy—and name—of existing funds in response to ESG’s ascent. Refine your greenwashing radar and dig into the details to ensure that firms are delivering on ESG objectives.

As in any industry, profit-minded investment managers align with rising trends to ensure their offerings appeal to a growing segment of the market. That can certainly contribute to a market bubble, but it does not guarantee one. Although the rapid growth in demand for ESG investments over the past couple of years may resemble bubble-like activity, market dynamics will ultimately determine how the situation plays out.

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