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There have not been many places for investors to hide from the equity sell-off this year and sustainable funds are no exception. The MSCI World index, for example, is down 14 per cent and its environmental social and governance (ESG) counterpart has lost 15 per cent.

One of the few sectors  that did well as a result of the war in Ukraine — energy — is largely shunned by sustainable funds. If you didn’t have Occidental Petroleum or Exxon in your portfolio like billionaire investor Warren Buffett, the odds are you’ve underperformed the market. Meanwhile, tech stocks, which ESG funds tend to own a lot of, had a terrible year.

So, assuming they won’t go down the dubious path of arguing that oil and gas stocks are now ESG-friendly because they contribute to energy security, how do sustainable fund managers plan to make money in 2023?

Most of the managers I spoke to for this column think the financial tide has turned, and not in a good way. The easy money just isn’t there any more, whether you’re investing sustainably or not. The rising tide of quantitative easing that helped to lift pretty much all equities over the past decade is gone. Higher interest rates and recessions are back. Many sustainable funds had a focus on so-called growth stocks — companies that are growing quickly, like tech companies or some renewables. But growth has had a bad year and instead value stocks — those undervalued by the market — have done better.

Yet asset managers are optimistic that sustainable funds will find opportunities to make money next year.

One obvious area is clean energy. Perhaps surprisingly, the sector didn’t do that well this year. Despite governments vowing to pivot away from Russian oil and gas and invest more in renewables, shorter-term effects got in the way. Wind energy companies such as Denmark’s Orsted and Spain’s Iberdrola suffered from supply chain issues. Higher interest rates played a role: renewable companies tend to have a lot of upfront costs that require borrowing, so when costs go up, they suffer. The good news is that the longer term case for renewables remains.

Lucas White, portfolio manager of the GMO Climate Fund, reckons the prospects for clean energy companies are much better now than at the start of the year. A lot of this is due to US President Joe Biden’s Inflation Reduction Act, which hands out significant tax credits to clean energy companies.

He is applying a quality bias to clean energy companies — avoiding more speculative stocks such as hydrogen companies that are not yet profitable in favour of more mature companies priced at reasonable levels. Companies with a unique advantage are also good picks in a more difficult market. First Solar, a US solar panels maker, has a product that works well in warm desert conditions, for example, making it one of the few solar companies with a differentiated offering. Biofuel companies, he believes, are a neglected niche and look very cheap.

Tom Atkinson, a portfolio manager at Axa Investment Managers, who works on the company’s clean economy strategy, is keen on US agriculture equipment makers, particularly those in sustainable or precision farming. Water is a key area that is undervalued, he thinks, with farmers under pressure to improve their efficiency and companies needing to treat and reduce water waste.

Other fund managers are looking at less obviously sustainable sectors, such as banks. Banks do play a crucial but often overlooked role in the energy transition, through lending to higher polluting sectors such as oil and gas companies. Mike Fox at Royal London reckons that financials have cleaned up their act in recent years: they offer simpler products to consumers, and they’re getting better at disclosing their loan books — which is key to being able to understand the carbon footprint of a company.

Fox thinks banks have the power to force consumer change through financial incentives. Lloyds, for example, offers lower mortgage rates for homeowners who make their homes more energy efficient. Banks with more complex business models, such as HSBC, are harder to analyse from an ESG perspective and less likely to be suitable, he thinks.

Simon Clements at Liontrust thinks that valuations right now are “pretty appealing”. He thinks that any recession will be consumer led but that businesses will fare better. “Businesses are in better shape and they will generally invest to improve their own efficiency and profitability,” he argues — which is good news for energy efficiency stocks.

The circular economy — where products are reused or recycled and waste is reduced — is on many sustainable fund managers’ radar. Jon Forster at Impax Environmental Markets rates software companies such as US-based Altair that help to make product manufacturing more efficient, as well as companies that use sustainable materials like Austria’s Lenzing or Royal DSM of The Netherlands, while equipment rental companies such as Herc Rentals help promote the sharing economy.

Forster says this year was not great for sustainable companies in the buildings, energy efficiency and water infrastructure sectors that were exposed to construction, where growth has slowed this year due to higher interest rates and waning consumer confidence. Swedish heat pump manufacturer NIBE, he says, was a “prime rotation victim”: it was already priced high and fared poorly as investors sold off expensive growth stocks. But he thinks that will change next year as investors focus more on the longer term need for energy efficiency. NIBE could benefit from the drive to decarbonise heating on the back of the war in Ukraine. Dutch companies Signify, which makes LED lighting, and Aalberts, in water infrastructure, will also have a better year, he thinks.

Healthcare also has enthusiasts among sustainable fund managers. Companies are likely to be more resilient in a recession and valuations are relatively cheap. Forster likes Cryoport, which makes reusable containers instead of Styrofoam to transport biogenic material, and Repligen, which helps drug manufacturing use less water.

Overall, fund managers think diversification is key in 2023, rather than the rising tide strategy of the past decade of simply buying growth stocks, sitting back and watching them go up. Royal London’s Fox reckons fund managers will have to learn or relearn key skills from the 1990s: price matters, and so do economic cycles.

That means next year we should find out who is actually good at sustainable investing in a bear market. With both institutional and retail investors becoming more savvy about greenwashing and growth no longer a given, sustainable fund managers will have to work hard to prove their worth.

Alice Ross is the FT’s deputy news editor. Her book, “Investing to Save the Planet”, is published by Penguin Business. Twitter: @aliceemross

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