The merits of energy transition funds

The theme of energy transition is now widely recognised among investors, with Schroders data showing 59% of global investors identifying this as a key priority for them. Capitalising upon this, asset managers have been increasingly launching specialised strategies exploiting this theme and based on transition funds.

These new funds have the long-term economic outlook in their favour. This is because the long-term case for the outperformance of companies that embrace the energy transition is strong, according to Jack Turner, investment manager at Seven Investment Management.

“The need to transition to cleaner energy solutions is increasingly being accepted by private and public sectors alike,” says Turner. “Many countries have signed into law the need to reach net zero, and clean energy is the key enabler for that goal. The legislation that was recently signed into law in the US will further drive interest in this sector and combines with similar legislation in Europe and China.

“Performance of these stocks was stellar in 2020 and 2021 but there has been a huge correction this year, meaning investors can access this long-term trend at P/Es that are much more attractive than last year.”

This structural change will bring about disruption, something that can benefit investors positioned in the right assets. However, engaging with this theme in portfolios is not as simple as buying a fund with “energy transition” in the name.

Caution over specific strategies

Energy transition funds have grown in popularity at a time when trend and thematic investing has become increasingly mainstream – something Elena Kosava, AJ Bell’s head of investment research, says investors should be cautious about.

“Responding to investor interest, asset managers delivered an ambitious abundance of product launches, often underpinned by engaging narratives,” she says. “Yet, experience tells us that it often requires more than an appealing narrative for thematics to generate consistent outperformance. Uncovering structural winners of long-term socioeconomic shifts is key.”

One challenge with these specific strategies is their focus on growth companies. Companies involved in energy transition as a theme are usually in nascent technology sectors, or at a startup or SME stage, which narrows the diversification they offer. Much of these companies’ value will be based on future profits and the reality of a world where energy has been transitioned.

“As we’ve seen this year, an increase in interest rates led to these profits being discounted at a much higher rate and this has been reflected in recent performance,” says Turner. “Investors need to be aware of this if they are to invest and realise that despite the long-term case for these stocks being sound, they can suffer from large corrections in certain environments.”

In agreement is Darius McDermott, managing director of Chelsea Financial Services and Fund Calibre: “Ultimately any growth-led sector like this – where companies have to put the money they have made back into the business to spend on the likes of research and development – are going to struggle when growth is out of favour. These companies tend to be growth-led, but not all of them.

“The other worry is that if everyone is investing in the same areas (through fund launches), it will push valuations up. Twelve months ago, all the socially responsible global growth funds were at the top of the tree, now they are down the bottom, primarily because they are growth funds.”

Benefits for portfolios

Despite concerns over the pitfalls a growth-bias may give these funds, they can bring benefits to portfolios. McDermott advocates accessing energy transition via a dedicated renewables fund or trust given the ability this affords investors to outsource complex transition decisions to experienced managers.

Using an experienced fund manager for these decisions, someone who knows the market inside out, can be invaluable. Here, Hawksmoor Investment Management chief investment officer (investment solutions) Richard Philbin says this is important to help investors avoid energy transition’s “losers”.

“I once read the best time to start to tackle the carbon problem was 25 years ago. The second-best time is today,” says Philbin.“ But there will be losers along the way.

“Consider all the dot.com businesses that raised lots of capital in the late 1990s that are not here today, but the internet still is. There will be companies that seem all encompassing in the net-zero space that might fall. There will be companies that start without legacy issues that traditional energy providers have that will take an initial lead and garner lots of excitement. They might fall by the wayside.”