It has been a turbulent year for environmental, social, and governance, or ESG, investing. Performance has been weak, and critics have questioned what the three letters have to do with saving the planet.
In July, BlackRock (ticker: BLK), the world’s largest asset manager and a vocal proponent of ESG investing, announced that it had supported fewer environmental and social shareholder proposals during this year’s proxy season, prompting further speculation on the future of ESG.
In our April 15 cover story, Barron’s warned that ESG, also known as sustainable investing, had hit a roadblock. Since then, the backlash—from insiders and outsiders—has intensified. The attention, many observers maintain, could bring about positive change.
“The rethinking that’s happening is almost definitional. What do we mean by ESG?” says Dave Nadig, financial futurist at VettaFi. “I think it’s healthy for us to have these conversations. I think it’s healthy to challenge different approaches and different asset managers.”
One of the key factors driving the rethinking of ESG investing is its recent performance, which in turn has been prompting outflows from ESG funds.
“ESG funds are more heavily weighted toward technology stocks. Year to date, tech has not done as well as energy stocks, so performance hasn’t been good,” says Ken Pucker, a senior lecturer at the Fletcher School at Tufts University.
For the first half of the year, sustainable funds in the U.S. underperformed both the overall equity market and traditional funds. If you compare the average return of sustainable funds in Morningstar’s U.S. large-blend category with the average return of all stock funds in the same category, sustainable funds lost 21.25%, versus a loss of 19.24% for the broader category, according to Morningstar Direct. The S&P 500 index finished the first six months of 2022 down 20.6%.
Sustainable fund flows have also fallen. In the second quarter, U.S. sustainable mutual funds and exchange-traded funds suffered outflows for the first time in nearly five years, shedding some $1.6 billion, to $296 billion in total assets at the end of June—the lowest level since the first quarter of 2021, according to a report from Morningstar.
“No question that the bloom is off the rose in terms of immediate flows on some ESG products,” says Nadig.
Still, the outlook for sustainable funds “remains bright,” says Alyssa Stankiewicz, associate director of sustainability research at Morningstar, but she acknowledges that views on ESG investing have become “a lot more mixed.” At the same time, she notes, she’s seeing increasing scrutiny from regulators on ESG strategies.
In May, the Securities and Exchange Commission put forward proposals on how ESG funds should be marketed and how investment advisors should disclose their reasoning when slapping an ESG label on a fund.
“The industry reckoning for ESG investing is not all bad news,” adds Stankiewicz. “It is a sign of growth and maturity when investors understand the terminology well enough to start pushing back. To a certain degree, I think the level of outcry that we’ve seen, to the extent that it increases investor transparency, is overall actually a win for sustainable investing.”
The Fletcher School’s Pucker, who has written extensively on ESG reporting and sustainability and closing the gap between rhetoric and practice, hopes that the re-evaluation of ESG investing prompts investors, he says, “who are concerned about both alpha and impact to ask harder questions [about their investments].”
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