Broadly speaking, large-cap stocks and exchange traded funds with the ESG label are performing admirably this year, but in many cases, those assets are lagging the S&P 500.
Investors considering funds such as the Calvert US Large-Cap Core Responsible Index ETF (CVLC) need to understand what’s hamstringing these ETFs this year. CVLC, which follows the Calvert US Large-Cap Core Responsible Index, has been a decent performer since coming to market in January. But it’d likely benefit if and when interest rates decline.
CVLC is heavy on growth stocks as highlighted by a 30.10% allocation to the technology sector. Fortunately, higher rates aren’t crimping that sector to the extent that was seen last year. But the Federal Reserve’s tightening campaign has sent 10-year Treasury yields north of 4.80% (as of Oct. 23). That dangerous flirtation with 5% is spooking market participants.
How Rates Are Affecting ESG ETFs
Most affected by rising interest rates are shares of renewable energy companies, including purveyors of solar and wind power. Fortunately, that’s not CVLC’s point of emphasis.
“Higher interest rates are impacting these companies’ finances,” opined Jeffrey Kleintop of Charles Schwab. “The stocks in the MSCI World Alternative Energy Index have a leverage ratio of 3.8, based on debt-to-12-month earnings, compared with just 1.1 for the five biggest energy producers by market capitalization. That means higher financing costs are much more costly for these companies.”
Arguably, there’s a twofold silver lining. First, perhaps CVLC is a baby that’s been thrown out with the bathwater. Second, interest rates won’t be high forever. Third, valuations on ESG stocks are coming down as a result of rising interest rates.
“The higher the discount rate, the lower the present value of future cash flows—especially cash flows expected in the more distant future. This can drive down the valuation measured by the price-to-earnings and price-to-cash-flow ratios,” added Kleintop.
Another upshot is that the long-term case for ESG investing isn’t being dented simply because of Fed tightening.
“What led many ESG stocks to give up all their relative gains wasn’t policy changes, earnings disappointments, or the cost of oil; it was largely the result of rising interest rates,” concluded Kleintop. “While higher interest rates may maintain the unattractive environment for ESG stock performance in the near term, should interest rates begin to decline it is possible alternative energy stocks could regain their lost luster for investors.”
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