Is the honeymoon really over for ESG funds?

After the worst quarter in its roughly two-decade history, ESG’s future is once again a subject of intense debate.

Against a backdrop of attacks by the Republican Party and lackluster returns, ESG funds in the US bled more than a net $5 billion in the final three months of 2023. Combined with a huge decline in the pace of inflows in Europe, the global market for funds claiming to pursue environmental, social or governance goals suffered its first-ever net redemptions last quarter, according to Morningstar Inc.

For some, it’s the latest nail in the coffin of an investing strategy that has become too politicized to survive. Industry executives close to the client flows in question offer a different picture.

Valentijn van Nieuwenhuijzen, head of sustainability for public market investing at Goldman Sachs Asset Management, says investors are witnessing a gradual maturation process that will culminate in ESG flows ultimately moving pretty much in lockstep with the rest of the market.

“As baseline sustainability integration increases, overall fund flows are likely to mirror broader trends in equity and fixed-income markets,” he told Bloomberg. 

ESG is becoming a tool for investors to ensure their portfolios aren’t overly exposed to any one risk, he said. “Sustainability-focused investors are increasingly looking to products that target differentiated themes within ESG or add balance to broader portfolios,” according to Van Nieuwenhuijzen.

Hannah Lee, JPMorgan Chase & Co.’s head of ESG equity research for the Asia-Pacific region, says there’s little to indicate that ESG is about to disappear. She also acknowledges the investing strategy is going through a rough patch.

“There are still robust pockets of demand for ESG investing,” Lee said. “But the recent underperformance of sustainable funds has been a challenge.” 

Last year, conventional green stocks were mostly a losing bet, with the S&P Global Clean Energy Index falling more than 20%. The index is down an additional 10% so far this year.

Investors redeemed roughly $13 billion from US-based ESG funds in 2023, the Morningstar data show. And even though flows into European ESG funds continued, it wasn’t enough to offset the declines in the US. In all, global net outflows totaled $2.5 billion in the fourth quarter, marking an all-time low for the ESG fund industry.

In Asia, where ESG has so far had less of a presence than in the US and Europe, JPMorgan’s Lee said the strategy’s weak performance relative to the wider market hasn’t helped. Morningstar estimates that $1.2 billion flowed out of Japanese ESG funds last quarter, while the rest of Asia saw negligible aggregate inflows, on a net basis.

“Performance has proved a headwind” and “flows to sustainable investing within the region have slowed,” she said. “But at the same time, the share of ESG funds being managed to a global mandate has grown to over 50%.”

Lee said it’s also “notable” that regulators across jurisdictions are hardwiring ESG into investing rulebooks. The upshot is that “sustainability remains firmly on the agenda,” she said.

Others in the industry are bracing for more pushback. 

“Given the challenging past year,” there’s likely to be “heightened scrutiny” around the ability of sustainable investing to deliver, said Nicole Lim, an ESG investment manager in fixed income at Abrdn Plc. “This goes beyond concerns about greenwashing risks,” she said.

Asset managers need to demonstrate “that sustainability and alpha generation can go hand in hand,” Lim said. The industry is under increasing pressure to document its claims, as the regulatory framework develops, she said.

Client redemptions last quarter left a bigger dent in ESG funds than in conventional portfolios, Morningstar’s data show. Net outflows represented a decline of 0.1% relative to total global sustainable fund assets. For the broader fund universe, net outflows were equivalent to 0.05% of the total, according to the researcher’s analysis.

ESG isn’t about to disappear, but there also are “urgent challenges that need to be addressed,” Lim said.

The comments add nuance to a debate that’s often characterized by hyperbole. Republicans accuse ESG of being woke, anti-capitalist and anti-American. Sustainable investing purists dislike the label because they say it’s morphed into a meaningless fee-generating machine as emissions and inequality rise.

At BlackRock Inc., Chief Executive Officer Larry Fink continues to talk about the importance of the energy transition. However, he has said he no longer wants to use the ESG label because he finds it too politicized. The last time the world’s largest asset manager mentioned ESG in an annual report to describe its engagement priorities with portfolio companies was 2022, according to an analysis by Bloomberg Law.

Overall, corporate executives are talking much less about ESG these days. Mentions of the label in fourth-quarter earnings calls with analysts and investors slumped to the lowest level since late 2020, according to data compiled by Bloomberg.

The polarizing nature of ESG has led a number of high-profile academics to argue in favor of retiring the label. Bob Eccles, a visiting professor at Oxford University who’s been writing about sustainability for more than a decade, has said the term ESG should be replaced with what he calls “material-risk factors,” which will continue to take important environmental, social and governance issues into account when making investment decisions.

“The term ‘ESG investing’ should just die,” Eccles said. 

Investors can still pay attention to the issues that ESG represents, even if they aren’t wedded to the label itself, according to Elizabeth Pollman, a law professor at the University of Pennsylvania, who wrote a working paper in 2022 exploring the origins and uses of ESG.

As examples, she cites safety issues at Boeing Co., unionization efforts at Starbucks Corp. and strikes at automakers. All are obvious ESG issues that not only ESG investors should worry about, she said.

“The utility of the term ESG has waned as it became embattled, but awareness about various issues under ESG has grown,” Pollman said.

Eccles said that without a well-defined approach to sustainable investing, fund flow data will provide little real insight into what investors really think. 

“ESG haters will celebrate outflows. ESG lovers will cry about them,” he said. For now, however, those numbers “mean nothing.”