Environmental, social, and governance investments have been all the rage over the past year, fueling speculation of a bubble forming in the popular asset category. However, the adoption of ESG is only in its early phase. The market has yet to become fully saturated.
“The shift to ESG appears to be still in its early innings. Investor positioning in sustainable equities is not yet overextended,” Karen Karniol-Tambour, co-chief investment officer for sustainability at Bridgewater Associates, said in the Financial Times.
Karniol-Tambour pointed out that ESG valuations appear in line with the broader market. Most common ESG indices exhibit very similar valuation characteristics to the broad market and remains roughly in line with a global equity portfolio. Specifically, the ratio of price to average earnings over the past three years remains at about 14.
Looking at the Bridgewater Associates “bubble gauge,” which combines traditional valuation metrics with factors such as the pace of new buyers and the amount of purchases funded with borrowings and whether priced-in conditions seem sustainable, Karniol-Tambour noted that only a handful of popular ESG stocks appear overpriced.
“The US ESG index looks very similar to the aggregate market, and much less frothy than stocks that have been most popular with retail investors where we think valuations are most stretched,” Karniol-Tambour said.
Karniol-Tambour, though, noted that a few sectors like renewable electricity have moderately higher valuations. Nevertheless, these segments only make up a small portion of market benchmarks.
The analysts attributed the similar valuations between ESG stocks and the broader market to the way ESG indices are handled. ESG indices follow the market relatively closely and intentionally avoid large deviations. Karniol-Tambour explained that they effectively cut out “the worst” companies instead of holding only “the very best.” Consequently, these ESG benchmarks appear a lot like a typical equity allocation.
Additionally, the gradual shift to sustainability has also helped ESG stock valuations remain in line with the broader market.
“We analysed the disclosed equity holdings of a group of institutional investors that have publicly expressed significant interest in ESG, accounting for about $1.5tn in public equity assets. The moves they have made so far have been gradual and are not nearly as big as it would take to fully align with ESG indices. But a greater shift is expected,” Karniol-Tambour added.
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