Environmental, social and governance funds may outperform the broader market this year due to their heavy holdings in tech titans, though the "ESGness" of such investments remains hotly debated.
ESG funds fared badly in 2022 amid higher interest rates and an energy crisis, with inflows tumbling 76 percent from a year ago, according to research house Morningstar.
This year, however, tech-heavy ESG equity funds are outperforming the market amid an artificial intelligence-related rally that has sent US chip giant Nvidia skyrocketing 200 percent, and Microsoft and Apple to record highs.
Among the best performers, Swedbank Robur Technology C, whose top two holdings are Microsoft and Nvidia, has seen returns of around 40 percent.
On average, ESG equity funds in Europe and the US tracked by Morningstar delivered returns of nearly 11 percent in the first half of 2023.
Swedbank Robur Technology C, which has held Nvidia since 2016, was the most exposed ESG fund to the world's most valuable chipmaker in June.
It is registered as an Article 8 fund under the European Union's Sustainable Finance Disclosure Regulation or SFDR.
Article 8 funds promote ESG characteristics without a specific sustainable investment goal, while Article 9 funds must have a clearly defined sustainable investment objective.
Many funds have reclassified as Article 8 or "light green" from the "dark green" Article 9 due to stricter reporting for the latter.
Europe dominates
There were 188 ESG funds authorized by the Securities and Futures Commission as of the first quarter of this year, up by 55 percent from a year ago, and their total assets under management were US$151.7 billion (HK$1.18 trillion) by the end of March, a year-on-year rise of 6 percent, according to the SFC.
Among the 186 funds on the SFC's website, more than 90 percent are domiciled in Europe and are SFDR-registered ones.
To get a better sense of investor appetite for ESG funds in Hong Kong, one should look beyond locally domiciled funds, says Bryan Cheung, associate director for manager research at Morningstar.
The SFC-authorized ESG fund that saw the highest return in the first half was Janus Henderson Horizon Sustainable Future Technologies Fund, which posted a 25.6 percent gain, Morningstar data shows.
The Article 9 fund has Nvidia and Microsoft as its top holdings but it is a relatively new fund and has lost 4.4 percent since its inception in August 2021.
Meanwhile, the best-selling SFC-authorized ESG fund in the first six months was Schroder International Selection Fund Global Sustainable Growth, which drew in an estimated US$1.2 billion during the period, according to Morningstar.
The Schroder fund, which has Microsoft and Alphabet as its top two holdings, has seen first-half returns of 14 percent. Its three-year and five-year yields are 47 and 83 percent respectively and the fund has an expense ratio of 0.84 percent.
Investors can buy funds directly from fund houses or through banks and insurance firms. For example, Standard Chartered Hong Kong offers 90 SFC-authorized ESG funds from different fund houses with a minimum investment of HK$1,000.
Among these, clients are more interested in equity and multi-asset funds, particularly those with regular dividends, StanChart HK says.
Pension fund, stock market choices
The Mandatory Provident Fund scheme also offers ESG choices. Sun Life Hong Kong has just launched a new MPF fund which tracks a global low carbon index provided by the FTSE, with a management fee of 1.1 percent while Manulife is to reposition two of its funds under the MPF scheme into ESG-themed products from October.
For listed ESG investment choices in the city, there are currently 12 exchange-traded funds, although their trading volumes are thin.
Among these, the Global X China Clean Energy ETF (2809) is the largest with HK$1.1 billion in assets.
The clean energy-focused ETF is mainly invested in A-share companies such as China Yangtze Power and China Three Gorges Renewables (Group).
The minimum investment is 50 units per board lot and it has an expense ratio of 0.68 percent per year. The fund has lost 14 percent this year but is still by 77 percent since its inception in 2020.
Meanwhile, there are four ETFs that track the HSI ESG Enhanced Index or its variation and have sizable stakes in tech giant Tencent (0700).
Among them, ChinaAMC HSI ESG ETF (3403) is the largest with HK$841 million in assets, and with the lowest expense ratio of 0.15 percent.
While many funds have performed well, the industry has not been immune to market nerves and dynamics.
ESG funds that invest in shares saw US$15.4 billion of net outflows in the second quarter, outpacing first quarter net inflows on economic and regulatory fears in Europe and concerns over the anti-ESG backlash in the US, according to Refinitiv.
And despite a rally in global markets, ESG funds in the US saw their fifth consecutive quarter of net outflows after a rough June, the data revealed.
Rating conundrum
ESG funds have traditionally been tech heavy and even Article 9 funds have the biggest exposure to the tech sector, according to Bloomberg Intelligence.
But while tech-heavy ESG funds are expected to fare better this year, the debate still rages on whether chipmakers are really environmentally friendly, and ESG ratings for tech firms remain under scrutiny as they can vary so widely.
For example, Nvidia is rated as low ESG risk by Sustainalytics, a sustainable rating agency owned by Morningstar, and the chip giant also has an AA rating from MSCI. But some argue that the rise of AI will lead to increasing popularity in computing-intensive applications, which may result in a rise in energy consumption.
In addition, sustanability ratings can differ wildly from one rating agency to another.
Sustainalytics gives Amazon an ESG rating of "high risk," ranking it 498 out of 502 firms in its retail industry group but MSCI rates Amazon's ESG score as "average."
Earlier, a report titled Sustainable Investing with ESG Rating Uncertainty published by the Journal of Financial Economics found considerable disparity across different ESG rating providers.
The report by four professors - who studied US stocks from 2002 to 2019 and examined the ratings from six major ESG rating providers including MSCI and Sustainalytics - found the confusion in the different ratings made sustainable investing riskier and decreased ESG-sensitive investor demand for stocks.
Compliance challenges
Apart from tech rating uncertainties, ESG funds are expected to face more scrutiny, and compliance costs could soar.
To prevent greenwashing, the EU introduced the SFDR's level one standard in 2021, requiring funds to be classified under certain categories such as Article 8 or 9.
The level two standard, which came into force this year, asked asset managers to report on a set of ESG indicators and metrics for their holdings.
Although the new rules were generally welcomed due to their aim to enhance transparency, critics say the definition of "sustainable investment" for Article 9 funds remains unclear and this confusion could hurt smaller companies more.
In a paper titled How Green is Dark Green? An Analysis of SFDR Article 9 Funds, professors Marc Chesney and Adrien-Paul Lambillon of the University of Zurich examined 290 Article 9 equity funds which involve 4,463 listed firms globally and found the current SFDR rule favors large corporations as smaller ones do not have sufficient resources to provide ESG data.
The industry is still digesting the changes but Hong Kong's regulators are believed to be headed in the same direction though the regulations would not be identical to the ones in Europes, Cheung says.
Last year, the SFC amended its disclosure rules on ESG funds, requiring them to disclose how they incorporate ESG factors, report and reference ESG criteria and release periodic assessments.
And the Hong Kong Monetary Authority is now seeking feedback on a green taxonomy framework in line with the Common Ground Taxonomy developed by China and the EU.
This suggests a possibility of more requirements on the basis of the upcoming classification standard, says Alan Au, the managing principal and APAC ESG lead at consultancy firm Capco.
