We discuss the ESG Orphans performance in Q1. This includes a reversal of 2022 trends along with the bloom wearing off the ESG rose. ESG outflows have started and inflows towards ex-ESG (our Orphans) have too. The ESG emperor is wearing no clothes. ESG assets are behaving as such. Risk-adjusted returns in ESG are negatively skewed as the effects of years of malinvestment and misallocation of capital are starting to be felt. The pendulum has shifted.

Q1 Report

Q1 is in the books. It sure was an eventful quarter with lots of moving parts. We had a major factor reversal to start the year (back into tech,) a new banking crisis, a potential end of Quantitative Easing (QE) and a Q1 Nasdaq close at 6mo highs. After lopsided sell pressure into year-end stretched the rubber band, it snapped back in Q1 2023.

Below we’ll discuss the ESG Orphans Index in Q1. We’ll also talk market developments, the connection to ESG and the ESG Orphans Index, and what it means going forward. Outflows from ESG have started. Our thesis on flows from ESG to ex-ESG (the Orphans) is playing out. The outlook remains for many more to adopt the Orphans.

The ESG Orphans Index, as measured by its tracking stock, ended down 2.04%. Last year’s winners in the market were Q1 losers, for the most part. Energy was a lagging sector in Q1 and the Orphans have 25% allocated to energy and that weighed on Q1 returns. After the energy outperformance of 2022, which the Orphans benefitted, it makes some sense that there was a pullback from the 2022 strong returns. Let’s dissect the ESG Orphans in Q1.

What Moved the ESG Orphans

For the quarter, the ESG Orphans Index as measured by its tracking stock ended down 2.04%. For a comparison in energy, the Energy Select Sector Index (tracked by the XLE) lost 5.37%. In the anti-ESG energy landscape, the Solactive United States Energy Regulated Capped Index (tracked by DRLL) lost 5.6%. Again, the leaders of 2022 took a breather to start 2023. Likewise, the ESG Orphans lagged. We think this is a mere respite in a broader underlying theme. We’ll dig into that more below. For now, let’s take a granular look at the other components of the ESG Orphans.

Nuclear energy makes up 25% of the ESG Orphans. As a proxy, the Utilities Select Sector Index (tracked by the XLU) ended down 4% in the quarter. Some ESG Orphan components include Nexterra (NEE, 5.37% weight) -7.8%, Duke Energy (DUK, 2.73% weight) -6.3%, and Southern Co (SO, 2.61% weight) down 2.56%. Early in Q1 rates were higher and as were rate expectations. This may have been the biggest headwind for utilities. Only in March, as rates eased, did these companies claw their way higher.

Alcohol and tobacco provided mix results to the Orphans. Dividends helped, as MO (3.59% weight) paid $0.94 or 2.1%, PM (6.32% weight) paid $1.27 or 1.34%, and BTI (3.35% weight) paid $0.67 or nearly 2%. That said, BTI lost 12% in price on the month, which hurt the Orphans. Alcohol saw a breakout in BUD (4.65% weight) as it gained 11.16%, closing at 13 month highs. Constellation (STZ, 1.3% weight) lost 2.55% while Diageo (DEO, 4.12% weight) gained 1.68%. Net/net it was a mixed bag for alcohol and tobacco in Q1.

The weapons’ sector of the Orphans, at around 21% of the basket, was mixed as well. The group was led by Boeing (BA, 5.22% weight) which gained 11.5%. This was offset by Lockheed Martin (LMT, 5.47% weight) which lost 2.83%, Raytheon (RTX (6.10% weight) which lost 2.96%, and Northrop Grumman (NOC, 2.86% weight) which lost 15%. The Russia/Ukraine situation has eased to some degree in the short term, potentially reducing expected demand. Overall, the weapons’ sector had a roaring Q4 of 2022 and some of the retreat in Q1 2023 was not all that surprising following that move. It’s not as if overall global bellicosity has diminished that greatly.

The ESG Orphans paid a Q1 dividend of $0.12 or around 0.60%. But net/net the Orphans lagged the broader market after delivering outsize returns in 2022.  This is to be expected in markets where the general trend is less clear. Market gyrations are normal in this environment and we expect that over time the ESG Orphans will continue to deliver great risk adjusted returns.

Now we’ll zoom out and discuss broader markets, the undercurrents causing bouts of volatility and impacting performance, and what it means for going forward for the markets as well as the ESG Orphans specifically.

Is a New Market Paradigm Upon Us?

Earlier we mentioned Q1 as the “Reversion of the 2022 reversion.” In the first weeks of 2023 there was a factor reversal. It was the opposite of 2022, when big tech and ESG got hit hard. The areas that advanced the most were the previously excluded and isolated sectors like our Orphans and value stocks. Year-to-date in 2023, the 2022 theme has reversed. This new year trend was clear and evident through the first week of February.

For a moment in February, it looked like the rebound was over. A specific date where the emergent theme stalled was February 2nd, Groundhog Day of all days! Amazon posted earnings and gapped up trading the 3rd most volume of the year. The next day it gapped down. That gap is still open and EPS’ day buyers are now trapped. Buyers on EPS’ Day are still down by 10%. (Coincidentally, Ford traded in a very similar pattern.) These technical patterns are very rare and powerful. We are keenly watching those two points in those two charts to gauge overall sentiment.

Following February 2nd, the market consolidated. For a lot of names and the broader markets, February was a month of retreat. Then in March, markets resumed lower through the first 10 days. That’s when we had the biggest financial event in nearly 15 years. We had the Banking Crisis of 2023. A complete failure of risk management and ESG-exacerbated problems (more on this later) caused Silicon Valley Bank (SVB,) a top 20 US financial institution, to basically go into receivership. The Fed came to the rescue and for all intents and purposes Quantitative Tightening (QT) ended and Quantitative Easing (QE) restarted.

From there, markets went straight up. As QE essentially restarted, so did the correlation between the Fed Balance Sheet and equity markets. After the Fed rescue, big tech led the way. Money markets saw big inflows. Bonds were sold as safety was sought in money markets AND big tech. That flight-to-quality pattern and security selection is noteworthy. The quick recap: A tumultuous 2022, a bounce in early 2023, a banking collapse, and everything is alright again. One word of caution amidst the rally is that the breadth has narrowed. The household names of Apple, Amazon, and Microsoft are among the biggest gainers. We believe that the mindset is something akin to, “Nobody loses their job for owning AAPL, AMZN, and MSFT.” The bulk of 2023 gains have come from the “Big 6” in tech.

One of those “Big 6” is NVDA, up nearly 90% in the quarter after being down 48% in 2022. It’s still down around 8% over the past 15 months. Call us old-fashioned value seekers, but we don’t see the “safety” in NVDA at 200x FCF, 25x sales, 157x p/e. But that is where many are hiding out now.

To summarize the past 3-4 months: First, massive tax-loss selling to end 2022 resulting in an underweight imbalance in stock positioning. Second, a factor shift back to tech and growth. Third, a relief rally following that unprecedented selling to end Q4. And fourth, a continuation of the countertrend rally due to a restart of QE. Early on we called this the “Reversion of the reversion of 2022.” It has persisted a bit longer than many thought it could. This is not uncommon for those who have been watching markets for a long time. Restarting QE was the tailwind to the recent rally.

Forces Driving the Market; ESG is Omnipresent

Net/net, if we zoom out, the overall markets have gone sideways for the greater part of a year or more. The SPX is nearly unchanged from 4 months ago, 11 months ago, and 2 years ago. It’s still about 14% off its all-time highs and 17% off its recent 2022 lows. The SPX has spent most of the past 5 months in a 10% range. The NDX is back to where it was in August and April of 2022 while still 22% below its all-time high.

Now let’s check under the hood and consider what’s been driving the markets. Those who have been following Constrained Capital know we’ve continuously talked about the biggest underlying factor in the markets, orders of magnitude greater than any other investment theme. The single biggest investment factor of the past decade is unquestionably ESG (Environmental, Social, and Governance) investing. In the previous 5 years alone, AUM in ESG has more than doubled (across all asset classes) from somewhere in the $15-17TLN area to upwards of $35TLN. ESG is pervasive in nearly every investment idea and ESG discussion. It’s as if no investment decision can occur unless ESG is mentioned in some form. For a while, all net inflows into the ETF space were to ESG.

QE and Zero Interest Rate Policy (ZIRP) distorted the investment landscape for much of the past decade. Post GFC (Global Financial Crisis) the only way forward (including Covid) was to flood the markets with money. This created major investment illusions. Nearly any investment idea was a good one. The cost of money was near zero during QE and ZIRP as there was little or no risk in putting money to work. This helped accelerate ESG investing. Soon enough, an “ESG” stamp or mention of ESG from anyone seeking funds or inflows was all it took to garner outsized capital. This enabled ESG to become the biggest investment factor over the past decade. ESG AUM is now in the multi trillions and fees associated with and collected by ESG purveyors are in the billions. It’s a gravy train.

In 2022 the rates’ paradigm shifted and the investment landscape changed dramatically. Suddenly investments like new hires and new capex fell under more PnL scrutiny because the cost of money was higher. Excess hires like Chief Sustainability Officers and speculative investment ideas in cryptocurrencies or NFTs or SPACs turned into mistakes and became more costly that much faster. When the two-year Treasury yield rose more than 5x from 0.75% to 4% in less than a year, a multiple standard deviation move, bad things happen faster. Early on, the investment environment was easy and tech companies over hired, stock prices ran up, and ESG was great. Then those tech companies were the first to fire hundreds of thousands of employees when things took a turn for the worse, rates went higher, and stock prices went lower.

We’ve been pounding the table on higher costs and lower returns in ESG along with failed objectives and massive amounts of risk created. This resulted in horrible risk/return profiles. The rating agency system, which we highlighted as a key ESG shortcoming in our intensive research over the past few years, has yet again failed Wall Street and hurt society and investors.

In Q1 2022, Russia’s ESG rating was higher than many other EU countries. Then it invaded the Ukraine. Later in 2022, FTX had a higher ESG rating than XOM in some categories before it collapsed in the biggest fraud of the year. More recently, SVB had a, “Medium ESG Risk” rating, yet no Chief Risk Officer for 8mos before it collapsed. How could SVB be “Medium” ESG risk with an abject “zero” in the “G?” Imagine a three-legged stool missing a leg. Nobody would sit on that stool yet so many “smart” investors were deeply involved in SVB. ESG was a recurring theme at SVB.

In the past we also discussed how cyclical Wall Street works. Back in 2007-2009 the Global Financial Crisis was exacerbated by the rating agencies like Fitch, Moody’s, and S&P rated Collateralized Debt Obligations (CDOs) as AAA when in fact they were junk. This nearly took down the entire financial system. This resulted in the Fed embarking on the greatest monetary expansion in the history of finance. This past month we had nearly a repeat in the cycle after a long build up over a handful of years. The symptoms are the same: Easy money, leverage, hubris, and ego combined with horrible risk management and blatant lack of regulatory oversight, and an outright failure by regulators. Sure the actors may have changed (although a lot of Fed and Treasury agents likely HAVE NOT, ironically enough) but the underlying causes and basic human nature did not.

We believe we are going to embark on a trying period for markets henceforth. Recently we heard Wall Street legend Leon Cooperman discuss the parable of Joseph and the idea of “7 lean years that follow 7 fat years.” He cited the prior decade as part of the “7 fat years.” We agree with him. We look at 2022 as the first in a series of “7 lean years.”

Now What, For ESG (Outflows) and the ESG Orphans (Inflows?)

2022 saw the ESG Orphans Index return 20% while the SPX fell 20% and the NDX fell 30%. That was the first year for our index and the first year of “proof-of-concept.” 2023 has thus far “zigged” after 2022 “zagged.” We think 2023 has been a simple correction in an underlying broader trend. Outflows have just started in the ESG world. Eric Balchunas of Bloomberg and Nate Geraci of the ETF Store, both of whose fingers are usually on the pulse of the ETF flows, cited the massive $6BLN in outflows from Blackrock’s ESG fund ESGU.

As anyone who knows Venn diagrams understands that flows out of one of the circles (ESG) mean flows into the other circle (ex-ESG) at least on a relative basis. Negative ESG attributes are piling up including: Higher fees, lower returns, failed objectives, and huge risks. The key in 2022 that kick started the ESG unwind was higher rates combined with the failed objectives and horrible risk-adjusted returns associated with ESG. Over time, this pendulum swing should further benefit the exclusions of ESG, our ESG Orphans.

Consider the recent outflows from Blackrock’s flagship ESG fund ESGU. $6BLN flowed out in the quarter and alongside that QUAL (part of Blackrock’s armada of funds) saw the biggest inflows. We highlight two takeaways: First, 60% of the top 20 names are the same in both. This is just a shuffling of paper among Blackrock clients. We’re suspect of the differentiation aspect for Blackrock clients. But it sure helps them deke their way out of “Too much ESG.” Classic Blackrock doublespeak. Second, and much more importantly for the ESG Orphans thesis, 4 of the top names in QUAL are ESG Orphans. Lockheed Martin (LMT,) Marathon Petroleum Corp (MPC,) Valero (VLO,) and Devon Energy (DVN,) are seeing inflows as money shifts out of this flagship ESG fund. This will continue. Imagine when other big asset managers see the same flight out of ESG funds.

This is a big part of our thesis. Outflows from ESG means inflows to ex-ESG. While the flow shift may not be one-to-one, if enough flows exhibit the same pattern, the ex-ESG space, our ESG Orphans, will see huge relative inflows. Given how big the ESG inflows were for a decade, the reversal of these flows could easily be the largest factor going forward and last quite a while. We envisioned this massive factor unwind and it was an impetus for the creation of the ESG Orphans. Consider the top 6 big tech combine for $9TLN in market cap while the top 20 energy stocks (fossil fuel and nuclear) in the ESG Orphans have a combined market cap of $1.9TLN. The tech group is 4.5x bigger than our energy group. The flow potential on a further ESG unwind is enormous. From ESGU to QUAL in Q1 was nearly the first of this flow move. It certainly is not the last.

This reversal started in 2022 as interest rates upset the landscape. Plenty of investment distortion caused by misallocation of capital and malinvestment from ESG was exposed. Returns in 2022 suffered. Outflows have begun in 2023. ESG has become a bit of a political hot button as well. We believe that the pendulum has started to swing in earnest. The ESG emperor is not wearing any clothes.

The risks in the ESG rating system that we talked about incessantly should be more than apparent now after Russia, FTX, and SVB. There are probably still more like this to come. The costs associated with ESG were somewhat hidden in those cases as a stamp of approval in ESG ratings masked a lot of underlying problems. What’s more apparent is the upfront costs in more hires, more compliance, more regulatory adherence, and even in the simple due diligence questionnaires that must be answered and then complied with. Forget for a moment that plenty of companies are “gaming the system” and know how to answer those DDQs. It’s more like they have been skating by as they, “Say good” more than they, “Do good.” This is an inherent problem in ESG that has existed for as long as the acronym has.

Going Forward

We see the Biden Administration trying to meddle further into the investing landscape and tell pension funds that they can continue to pursue ESG ideologies in their investments. We believe this is the equivalent of “doubling down” on a trade that’s gone horribly wrong. This move creates more fiduciary liability and removes responsibility from investment professionals. This does a disservice to investors and as we have seen over the past year. It hurts society and the economy overall. It erodes trust in the system diminishes due diligence and deep-rooted research in favor of opinions and subjective reasoning.

We created the ESG Orphans to help investors assuage ESG risk. It worked in 2022 as the ESG Orphans outperformed. Now the paradigm has shifted, and the bloom is off the ESG rose. Sure, Q1 2023 saw the ESG Orphans lag. Not unexpected after 2022. In addition, the dispersion between ESG Orphans and the broader market (aka tech and ESG favorites) has created a further disparity between what is expensive (tech) and what is cheap (the Orphans.) This is an opportunity for long-term ESG Orphan investors.

It’s a perfect time to consider the ESG Orphans as a balance to portfolios. Sure there is room for some risk taking in some elements of a portfolio like the NDX Index (tracked by the QQQ, +20% YTD vs. -33% in 2022) or Cathie Wood’s ARK Investment (tracked by ARKK +29% YTD vs. -67% in 2022.) We think it’s quite risky to be buying big tech here after this past quarter’s run. But a balanced portfolio and a “barbell” strategy could include the ESG Orphans to offset heightened risk in the tech sector and growth areas of market currently.

The ESG Orphans screens as value as they are cheap to most things. The Orphans pay a solid dividend, in some cases more than “Dividend aristocrat” funds. It has a low beta to the SPX (0.80) and is defensive in nature. All that said, the major tailwind and underlying factor behind the ESG Orphans is that it isolates the ESG factor which unquestionably is the biggest investment factor of the past decade. We believe this factor is reversing and the pendulum has begun to swing the other way. Flows and evidence support this thesis.

The ESG Orphans can help investors manage oncoming ESG risk. This risk surfaced in 2022 and may persist for quite a while longer. Over the medium- and longer-term horizons, we expect a further, greater reversion back towards the ESG Orphans and away from the ESG bubble that preceded it.

Thank you for your support.

Mark Neuman is the CIO/Founder of Constrained Capital and creator of the ESG Orphans Index and the ETF that tracks it, $ORFN.

Please visit our websites: www.esgorphans.com and www.constrainedcapitaletfs.com for more information. Reach me directly via email at mark@constrainedcapital.com. Follow us on Twitter @MarkNeuman18 and @ESGOrphan.

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Past performance is not indicative of future performance. Index returns above are for illustrative purposes only. They do not represent actual trading in investable assets and securities. They also don’t account for fees or expenses in trading. You cannot invest directly in an index.

This document is not a recommendation or suggestion of any investment ideas. It is not an offer to buy or sell any securities. It’s for discussion purposes only. Please consult your financial advisor and perform due diligence before making investment decisions.

The SPX Index or S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.

The NDX Index is a stock market index made up of 101 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange.

The Invesco QQQ ETF is an exchange-traded fund (ETF) that tracks the Nasdaq 100 Index.

The Utilities Select Sector Index is a modified capitalization-weighted index representing the performance of utility companies that are components of the S&P 500 Index.

The Energy Select Sector Index is a modified capitalization-weighted index representing the performance of energy companies that are components of the S&P 500 Index.

ARK Innovation ETF, also known as ARKK is an actively managed Exchange Traded Fund (ETF) that seeks long-term growth of capital by investing under normal circumstances, primarily in securities of companies that are relevant to the theme of disruptive innovation.

Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market (usually the S&P 500).

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