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    Rise of AI Slows Article 9 Performance in First Half of 2023

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    Stockholm (NordSIP) – Having previously explored the performance of Nordic-based equity and fixed-income funds classified under Article 9 of the EU’s Sustainable Finance Disclosures Regulation (SFDR), NordSIP took the occasion of the summer break to reach out to international asset managers and hear about their performance during the first half of 2023.

    The survey was able to collect information on the performance of 16 global equity funds and 5 global fixed-income funds, from non-Nordic asset managers with whom NordSIP has an ongoing partnership. The nature of sector and stock selection in selecting sustainable investments played a crucial role in creating an environment that caused most funds to underperform. The importance of IT and Article 9 funds’ underexposure to this sector during a time of rising interest in AI was the most consistently mentioned theme by surveyed portfolio managers.

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    Relative Performance

    Among Article 9 SFDR global equity funds, the review considered 7 contributions from BNP Paribas, 4 from Federated Hermes, 3 funds from BlackRock, 2 funds from Stewart Investors as well as Royal London’s RL Global Sustainable Equity Fund and the WHEB Sustainable Impact Fund. Priority was given to funds for which it was possible to calculate the relative performance in Euros based on the information available.

    Royal London’s RL Global Sustainable Equity Fund, the Federated Hermes Sustainable Global Equity Fund and BlackRock’s BGF Future of Transport Fund were the only funds that outperformed the relevant MSCI World indices. Sector selection was the dominating factor determining performance according to the portfolio managers surveyed, who highlighted the importance of developments in IT, but also in Healthcare, Materials, Utilities, Consumer Discretionary and Consumer Staples.

    Relative Performance of Selected Global Article 9 SFDR Equity Funds in EUR (1H 2023)

     Note 1: * the fund has no official benchmark. The most relevant comparison index used was suggested by the manager. 

    Among article 9 fixed-income global funds from non-Nordic partner managers registered in the Nordics, NordSIP was able to receive feedback from the portfolio managers of Royal London’s RL Global Sustainable Credit Fund, the responsAbility Impact – Transition to Net Zero Fund and the BNP Paribas Funds Green Bond Fund. Duration appears to have been the key performance driver in this market.

    Relative Performance of Selected Global Article 9 SFDR Fixed Income Funds in EUR (1H 2023)

     

    MSCI Indices and the Magnificent 7

    To understand the role of sector selection as a determinant of performance, it is important to consider the makeup of the MSCI indices used to benchmark fund performance. According to MSCI Research’s Hitendra Varsani and Juan Sampieri, the performance of the big tech firms was one of the dominating themes of the first half of 2023, in stark contrast with the trend in 2022. “In the second quarter of 2023, the MSCI ACWI Index gained 6.3%, extending the year-to-date gain to 14.3%, led by strong earnings from the technology sector. Among a universe of 3,014 stocks, only about 26.5% outperformed the index in the year to date, making it a challenging environment for active managers. The “Magnificent Seven” (Apple Inc., Microsoft Corp., NVIDIA Corp., Amazon.com Inc., Meta Platforms Inc., Tesla Inc. and Alphabet Inc.) contributed more than 50% of index returns (close to 70% for MSCI USA Index), reflecting the concentration of outsized returns in mega-caps,” Varsani and Sampieri say.

    The relative importance of these stocks in the performance of the MSCI ACWI is natural, given that these companies are its top 7 holdings and represent 16.5% of the index. These companies have an even more important weight on the MSCI World Index, where they are also the top 7 holdings but represent 18.4% of the index. The importance of these stocks is also patent in their correlation to the relevant MSCI indices, which is never below 84% since 2008 and often above 90% (based on data from Yahoo Finance).

    The importance of this theme cannot be exaggerated when considering the relative performance of Article 9 SFDR funds during the first half of 2023. Reviewing their performance during this period all of the portfolio managers surveyed mentioned this dynamic as crucial to understanding their performance. While there were some exceptions, the dominant trend was for Article 9 SFDR funds to be underexposed to the IT sector in a way that led them to underperform their benchmark.

    The oversized role of these stocks in the benchmarks also spills over into sectoral analysis. Aside from the IT sector, the Consumer Discretionary sector, of which Amazon and Tesla are two prominent examples and Communication services, which Alphabet and Meta are classified as also feature in the feedback provided by portfolio managers.

    Many of these companies have faced controversies (e.g.: Alphabet and Meta) and issues with labour practices (e.g.: Amazon and Tesla) and have been excluded from sustainable investment portfolios. Unless otherwise connected with the digital world, sustainable funds’ relative performance suffered due to these choices. The underweighting of the IT sector in general, or the exclusion these companies in particular, was a drag on the performance of most sustainable funds surveyed. The managers of the Stewart Investors Worldwide Sustainability strategies, the BGF Future of Transport Fund and the BNP Paribas Funds Climate Impact, BNP Paribas Global Environment Fund all made specific reference to their inability to benefit from the headwinds created by “mega-caps” in the first half of 2023.

    From left to right: Hubert Aarts, David Winborne, Siddharth Jha, BNP Paribas

    “The seven highest weighted benchmark names (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta) accounted for a substantial portion of the overall MSCI ACWI Index return during the first half. With the exception of Microsoft which has been a portfolio holding since 2021, a lack of participation in the mega cap rally created a challenging environment for the strategy,” said Hubert Aarts, David Winborne and Siddharth Jha, managers of the BNP Paribas Global Environment Fund. “In relative terms, the MSCI ACWI index benefitted from strong performance by the US mega-cap technology companies,” Stewart Investors agreed.

    The Cost of Underweighting IT During the Rise of AI

    The consensus among the surveyed managers was that the IT theme became relevant during the first half of 2023 because of the rise of AI services and the perception that there was enormous room for growth in this field. Whilst funds exposed to this trend were able to benefit from it, the large majority of the funds surveyed were underweight on this trend and thus underperformed the benchmarks.

    George Crowdy, Royal London Asset Management

    “One notable observation of the performance in H1 2023 was that performance was driven by companies exposed to both the physical and digital economies. Many companies we invest in are enablers and beneficiaries of the advancements in artificial intelligence where this excitement and growth supported the shares of cloud computing, semiconductor and software companies,” George Crowdy, manager of the RL Global Sustainable Equity Fund, argued.

    Justin Winter, BNP Paribas

    “Sector allocation was the main reason behind the underperformance, particularly due to the fund’s underweight to Information Technology and Consumer Discretionary which have been the best performing sectors on the back of the artificial intelligence (AI) enthusiasm,” said Hubert Aarts and Justin Winter, managers of the BNP Paribas Aqua Fund. This was also true for most of firm’s funds considered, with the exception of the BNP Paribas Funds Climate Impact Fund. “Sector allocation was the largest contributor to relative performance due to the strategy’s overweight to Information Technology,” said Bruce Jenkyn-Jones, Jon Forster and Fotis Chatzimichalakis, managers of the BNP Paribas Funds Climate Impact Fund.

    From left to right: Bruce Jenkyn Jones, Jon Foster, Fotis Chatzimichalakis, BNP Paribas

    According to Alastair Bishop, manager of BlackRock‘s BGF Future of Transport and of the BGF Sustainable Energy Funds, The importance of IT was also not just confined to software or online services. “Businesses involved in the development and production of semiconductor chips used in clean transportation also performed well, benefiting from strong underlying demand and broader market tailwinds,” Bishop added.

    Alastair Bishop, BlackRock

    Other Sectors Dynamics

    The performance of other sectors was salient due to the over- or under-exposure of the funds, depending on whether the sectors were positive or negative. Asset managers mentioned developments in Financials, Healthcare, Materials, Energy efficiency, Consumer Discretionary and Consumer Staples and macro dynamics as relevant to their funds’ performance.

    The first half of the year was also characterised by a lot of turbulence among financials, including the collapse of Silicon Valley Bank and other regional US banks, the acquisition of Credit Suisse by UBS and downfall of crypto-currency exchange FTX. This also affected the performance of Article 9 funds, through their exposure to small cap stocks, according to Ulrik Fugmann and Edward Lees, managers of the BNP Paribas Energy Transition Fund. However, while Fugmann and Lees note that investors have been concerned about the ability of small companeis to access capital, they also argue that “these concerns are transitory” and that the difference in funding costs between small cap and large cap is narrowing.

    Ulrik Fugmann (left) and Edward Lees (right), BNP Paribas
    Ted Franks, WHEB

    Investors in Healthcare, such as Ted Franks, Partner and Fund manager at WHEB, argued that the sector was a “drag on performance” due to “weaker instrument demand”. BNP Paribas Global Environment Fund’s Aarts, Winter and Jha described “concerns around slowing instrument sales due to recessionary fears, de-stocking headwinds, and a slow-down in early-stage biotech business.”

    Materials was also labelled a “laggard” by BNP Paribas Aqua Fund’s Aarts and Winter. The weakness of this sector was “chiefly due to weak performance of ingredient stocks affected by channel destocking and weakening consumer environment.”

    Sumana Manohar, BlackRock

    According to Sumana Manohar, manager of the BGF Circular Economy Fund, Consumer Discretionary did well thanks to “consumer resilience”, while Consumer Staples “contributed positively to returns” and that a “overweight position in European consumer stocks contributed to relative performance.”

    The Broader Perspective

    From a macro perspective, policy and inflation were the main factors mentioned. Both RL Global Sustainable Equity Fund’s Crowdy and the WHEB’s Franks noted the importance of the US Inflation Reduction Act in attracting sustainable investments. However, there was no such consensus regarding inflation.

    BNP Paribas Global Environment Fund’s Aarts, Winbourne and Jha noted a “reversal of previous inflationary pressures, due to lower energy prices and easing of supply chains disruptions, is expected to bring some margin of relief to businesses.” BNP Paribas Smart Food’s Michael Landymore and Agne Rackauskaite argued that “as inflationary pressures subside and supply chain disruptions ease, corporate margins should get some relief, particularly for those companies whose business models afford pricing power”.

    Agne Rackauskaite (left) and Michael Landymore (right), BNP Paribas

    BNP Paribas Funds Climate Impact’s Jenkyn-Jones, Forster and Chatzimichalakis explained that “the ongoing normalisation of energy prices and the easing of the supply chain disruptions have provided relief to businesses enabling them to operate more efficiently and with better cost control.” However, the BGF Circular Economy Fund’ Manohar argued that “companies are facing raw material price inflation and supply chain disruption. These challenges are providing incentives to switch to a circular model with local and domestic suppliers and use recycled inputs which are not subject to the same price volatility or logistics and supply chain issues.”

    Duration Rules in Fixed Income

    Among fixed income investors, insights were more technical, focusing on the rising interest rate environment and duration rather than on any specific sector.

    Arnaud Guilhem Lamy, BNP Paribas

    Arnaud-Guilhem Lamy, manager of the BNP Paribas Funds Green Bond Fund, argued that “the most significant performance drivers are the interest rates exposures ( modified duration and curve positioning) and credit positioning.”

    Susanne Kundert, responsAbility

    “We gear the portfolio active on top-down (duration & credit exposure) and bottom-up on sector, issuer and bond selection. The overall outperformance has been achieved mainly on bottom-up selection since we were over time fairly neutral on the top down selection,” said Susanne Kundert, manager of the responsAbility Impact – Transition to Net Zero Fund.

    Rachid Semaoun, Royal London Asset Managers

    Rachid Semaoune, manager of the RL Global Sustainable Credit Fund, noted that “the fund is essentially flat versus its benchmark for the first half of 2023. The fund’s duration position relative to its benchmark had a positive contribution to performance.” On a sectoral note, he argued that there was value in a more nuanced approach to banks. Although “the fund’s overweight in banks and insurance had a positive contribution to overall performance, the sustainability restriction to underweight to US banks was positive for overall performance.”

    The Path Ahead

    The consensus among managers was for the present trends to persist.  “We believe we are very early in trends such as artificial intelligence and the ongoing digitalisation of all sectors, combined with the electrification and decarbonisation of the physical world. We expect these structural trends to provide a supportive backdrop for many of the companies we hold. Assuming the macro backdrop remains similar in H2 as it was in H1 we would expect performance to come from many of the same areas given the powerful tailwinds these businesses are experiencing,” RL Global Sustainable Equity Fund’ Crowdy argued. “We expect that the drivers of performance in 2H 2023 will be similar to those that have affected markets year-to-date, namely inflation and interest rate expectations,” WHEB’s Franks added.

    Short-term stability was also the dominating factor among fixed-income. “For the second half of 2023 it will be precisely the same. We believe the asset class is currently offering a nice yield and carry, but the risks on the downside remain significant also for the upcoming six months,” responsAbility’s Kundert. More technically, RL Global Sustainable Credit Fund’s  Semanoune expects ”further spread compression between financial and non-financial bonds”, while commodity companies should “underperform over the longer term and to face higher funding costs, as Western economies continue to decarbonise”.

    However, as far as change is concerned, the focus will remain on monetary policy. “A lot will depend on the main global Central Banks, namely the US FED and the EUR ECB : their monetary policy decisions, and their impact on both inflation and the economic activity,” BNP Paribas Funds Green Bond’s Lamy argued. “the fund will maintain its long US duration relative to its benchmark as we expect the US Federal Reserve to be the first central bank to end its monetary tightening policy,” Semaoune added.

    Images courtesy of Steven Hodges and Michael Walter/Troika
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