FA Alpha Daily

The reversal of fortune for ESG investing in 2023

The rise of ESG investing coincided with a growing emphasis on ethical investment goals. However, recent withdrawals indicate a change in direction, and despite lagging performance, the worldwide drive for ESG investment highlights the importance of consistent transparency and convincing, enduring returns to regain confidence. In today’s FA Alpha Daily, we’ll delve into the factors contributing to challenges in ESG investing and examine approaches to address them.

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Environmental, social, and governance (“ESG”) investing has been gaining popularity in recent years as investors increasingly prioritize sustainability and ethical considerations in their investment decisions.

However, the allure of ESG investing seems to be fading away with new outflows from ESG ETFs since the beginning of 2023.

In the fourth quarter alone, investors withdrew $5 billion from sustainable open-end and ETFs. This marked the fifth straight quarter of net outflows from sustainable funds.

Throughout the year, a total of $13 billion was pulled from US sustainable funds, overshadowing positive flows in Europe and dragging down the global market.

This downturn was largely caused by macroeconomic factors such as global supply constraints, geopolitical tensions, and high interest rates. Plus, political scrutiny and regulatory ambiguity surrounding “greenwashing” contributed to a lack of investor confidence.

iShares ESG Aware MSCI USA ETF (ESGU), often referred to as the flagship ESG fund in the US, has been also struggling recently.

Launched in late 2016, ESGU tracks the MSCI USA ESG Select Index, which consists of large-capitalization stocks selected based on ESG criteria.

ESGU’s composition includes giants such as AAPL, AMZN, MSFT, GOOGL, and META. These companies are known for their innovative approaches to addressing various ESG issues, ranging from renewable energy initiatives to diversity and inclusion programs.

Since its launch, ESGU has delivered strong performance, outperforming both traditional index funds and many peer ESG funds. However, in 2023, ESGU’s performance has fallen short of expectations.

Since the start of 2023, ESGU has experienced significant outflows, losing almost $6.2 billion in net assets. This trend is in stark contrast to the fund’s historical success, having attracted $15.4 billion in inflows just a year before.

Several factors have contributed to this performance;

Political scrutiny and regulatory ambiguity regarding “greenwashing,” or misleading claims about environmental responsibility, have led to a loss of investor confidence.

The Securities and Exchange Commission (“SEC”) has been cracking down on companies that make false or misleading ESG claims, which has led to increased skepticism among investors.

Additionally, the lack of a standardized ESG reporting framework has made it difficult for investors to compare ESG funds and assess their impact.

Furthermore, the underperformance of ESG funds relative to other funds, particularly when comparing sustainable equity funds to non-ESG counterparts, has raised questions about whether ESG investing delivers superior returns.

While ESG funds have generally outperformed non-ESG funds in recent years, the performance gap has narrowed in 2023.

This has led some investors to question whether ESG investing is worth the higher fees that ESG funds typically charge.

Despite these challenges, it should be noted that overall, sustainable funds have seen positive net sales so far this year, except for ESGU.

Additionally, while US sustainable funds experienced their worst year on record in 2023, they continue to grow globally due to increasing commitment to green energy transitions.

To address the challenges facing ESG investing, there is a need for greater standardization and transparency in ESG reporting. This will help investors to compare ESG funds and assess their impact more accurately.

Additionally, ESG fund managers need to demonstrate that they can deliver superior returns over the long term to justify the higher fees that ESG funds charge.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.

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