Global investors are increasingly retreating from sustainability-focused stock funds, a trend driven by a confluence of weak performance, scandals, and political assaults in the US.
Between January and April this year, ESG (environmental, social, and governance) equity funds suffered net outflows amounting to $40bn, according to Barclays, marking the first year of negative flows. Notably, April saw a record withdrawal of $14bn.
But the long-term viability of ESG investing remains positive, with major implications for the broader market for sustainable investments. The current turmoil offers valuable lessons for investors to heed.
Several factors have contributed to the significant net outflow from ESG equity funds, once heralded for their ethical and financial promise.
The poor performance of these funds compared to conventional ones has been a major factor. ESG funds have consistently underperformed, with an 11% return versus 21% for traditional equity funds over the past 12 months, according to Morgan Stanley.
The clean energy sector has struggled to deliver expected returns, while stocks of fossil fuels soared due to rising energy costs and geopolitical tensions, such as the war in Ukraine. This disparity in returns has prompted many investors to revert to more traditional, higher-yielding investments.
Political opposition has also played a critical role. In the US, the political landscape has turned increasingly hostile towards ESG investing. Republicans have launched investigations into major firms like BlackRock, prompting its CEO Larry Fink to distance himself from the term ESG, claiming “it’s been entirely weaponized”.
This political backlash has caused some investors and companies to engage in “green-hushing”, where discussions about green investments are conducted quietly to avoid controversy. Overall, the politicization of ESG has sapped investor sentiment, making it a contentious issue in the US financial markets especially.
Scandals within the ESG sector have further eroded investor confidence. Cases of greenwashing, where companies misrepresent their environmental efforts, have undermined trust in ESG funds. For example, German asset manager DWS paid a $19m fine for greenwashing last year.
Combined with the broader market sentiment favoring higher returns from traditional equities, many investors are opting to revert to these more conventional funds.
Some wealth managers believe that ESG investments will perform better as the global economy recovers, with opportunities in energy transition and decarbonization.
The negative trend in ESG equity funds could have several implications for the broader market for sustainable investments.
In the short term, there may be a continued shift back to traditional investments as investors chase higher returns. However, some experts believe that green assets will outperform in the medium to long term. For example, Paul Polman, the former CEO of consumer goods juggernaut Unilever, has made the case that ESG investing “pays off”. Microsoft co-founder Bill Gates has said that ESG investments “come with lower risk profiles”.
In my view, those investments can deliver competitive returns, because climate change remains a significant concern, and regulatory pressures will likely increase, making green investments potentially more attractive over time.
Already, net inflows from ESG equity funds turned positive in May, Barclays said. Some wealth managers believe that ESG investments will perform better as the global economy recovers, with opportunities in energy transition and decarbonization.
Lower valuations, improved regulations, and new sustainability labels from the UK’s Financial Conduct Authority (FCA) for investment funds with different sustainability goals also contribute to this positive outlook.
Furthermore, despite the challenges faced by green equity funds, ESG bond funds have continued to attract inflows, gathering $22bn by April of this year, according to Barclays. This trend suggests a nuanced investor preference for sustainable investments.
One growing segment of green debt is bonds aimed at preventing biodiversity loss and protecting nature. These biodiversity bonds now represent nearly one-third of all ESG-labeled debt issued this year, up from 3% in 2015, according to Pictet Asset Management. The rise is driven by stricter regulatory frameworks, rising investor demand for sustainable investments, and favorable financial returns.
ESG-labeled debt is particularly appealing to institutional investors like pension or sovereign wealth funds, which need to demonstrate their efforts in green investments. These bonds also provide a way for companies to improve their public image and raise capital to do good.
Furthermore, with elevated interest rates globally, bonds with higher yields have become more attractive, making ESG debt an appealing option for investors seeking stable returns while hoping to make the world a better place.
And while US political attacks on ESG investing have dampened investor sentiment, regulatory frameworks in Europe are generally more supportive of ESG investments. For example, the European Union has developed the EU Taxonomy, a classification system that defines what constitutes environmentally sustainable economic activities. This helps investors identify and invest in sustainable projects and activities.
This increased transparency will likely make greenwashing more difficult and improve investor confidence in genuine ESG initiatives.
These regulations are part of a broader trend towards increased accountability and transparency in corporate reporting, aiming to ensure that companies take genuine steps towards sustainability, rather than merely paying lip service to these goals.
Fund managers and investors can draw several lessons from the recent ESG equity fund outflows. Despite short-term pressures, sticking with sustainable investment strategies will very likely pay off in the long run. As regulations evolve, ESG investing will become more sophisticated. Investors will need to focus on the fundamentals of companies, rather than relying solely on ESG ratings, which can be inconsistent.
Additionally, many regulators aim to attract more private capital into the green transition, a key goal of the EU Taxonomy. This influx would benefit ESG investors by accelerating sustainable technology development and adoption, improving environmental outcomes, and enhancing the performance and attractiveness of ESG investments.
For this reason, I believe the long-term viability of ESG investing, despite current challenges, remains robust. After all, climate change continues to be an urgent global issue, and its impact on economies and industries cannot be ignored. As climate-related events become more frequent and severe, there will be increased pressure on companies to adopt sustainable practices.
For example, companies may need to invest in renewable energy sources to reduce their carbon footprints, implement water conservation measures to cope with droughts and develop resilient supply chains to withstand extreme weather events.
Furthermore, regulatory frameworks are likely to continue to evolve, pushing companies towards greater transparency and accountability in their environmental and social impact.
Investors and fund managers who remain committed to ESG principles may find themselves well-positioned to capitalize on the long-term benefits of sustainable investing. As more data becomes available and regulatory frameworks become more stringent, the potential for greenwashing will diminish, leading to a more reliable and robust ESG investing landscape.
So, while the landscape is currently facing big challenges due to political attacks, poor performance, and scandals, the fundamental focus on environmental and social risks is likely to persist.
The increased issuance of green bonds and the push for more transparent regulatory frameworks suggest that sustainable investing will continue to evolve and regain favor in the financial markets.
Investors and fund managers who stay the course and adapt to the evolving regulatory landscape will be well-positioned to benefit from the future growth of sustainable investments.
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