Difficulties in definition continue to thwart efforts to demonstrate the financial benefits of sustainable investments.
Sustainable fund flows attracted US$37 billion of net new money in Q4 2022, with global sustainable fund assets reaching a total of US$2.5 trillion by end of the year, according to data and research provider Morningstar.
This suggests steady growth in the teeth of last year’s energy price crisis. But it also reflects the challenges of defining sustainable investing. Morningstar excludes many types of ESG funds, including those employing exclusions and integrations, meaning its totals fall well short of the US$35.3 trillion trumpeted by the Global Sustainable Investment Alliance’s 2020 report.
Nevertheless, a “significant evolution” of the ESG and sustainability-related fund universe has taken place over the past decade, testament to institutional investors’ growing appetite to contribute to and drive sustainable change, Carol Thomas, Head of Sustainability and Responsible Investments at the UK’s Investment Association (IA), tells ESG Investor.
“More recently, climate change, and concern about the environment more generally, has given a defining impetus to ESG and sustainable investing, alongside a range of wider social considerations,” she says.
“At the same time, the investment process has become more sophisticated in terms of selection, monitoring and company engagement, [and] regulation has been an increasingly strong driver of change as public authorities introduce more stringent requirements with respect to the net zero transition.”
High institutional appetite for ESG and sustainable funds is expected to continue.
A 2022 PwC report noted that investors globally are expected to increase their ESG-related assets under management across mandates, mutual funds and private markets to US$33.9 trillion by 2026, up from US$18.4 trillion in 2021.
In October, Morningstar published its second annual ‘Voice of the Asset Owner’ survey, which revealed that two in three surveyed asset owners (67%) believe ESG has become more material to investment policy in the past five years and subsequently plan to increase their allocations to ESG strategies.
Nonetheless, recent market volatility has provided evidence that investors’ commitment to sustainability can still be shaken.
After all, the fiduciary duty of an investor is widely considered to be about delivering strong financial returns on investments, despite ongoing reappraisals of the term in some jurisdictions.
And recent geo-political developments have changed perceptions and priorities for some.
“Nowadays, investor appetite for ESG has definitely cooled down a bit, given issues like energy security and the politicisation of ESG,” asserts Philipp Aeby, CEO and Co-founder of ESG data science firm RepRisk.
Is demand for ESG-branded investments rising inexorably, driven both by policy change and an increasing alignment of profitability and sustainability, or is it falling off, with long-term considerations subject to the appeal of a quick buck in an uncertain world?
In theory, investing in a sustainable tomorrow would drive demonstrably strong and consistent financial returns, while investing in anything opposed to that future would underperform in comparison.
But, as the wide range of opinion and findings outlined in academic and industry research shows, assessing demand for and performance of ESG and sustainability-labelled funds versus their traditional counterparts is not so simple.
In the weeds
One of the most comprehensive studies of ESG fund performance was conducted by Rockefeller Asset Management and NYU Stern Center for Sustainable Business.
Researchers analysed evidence from over 1,000 studies published between 2015-20 (most were written before 2015). They found a positive relationship between ESG and financial performance for 58% of studies focused on operational metrics, such as return on equity (ROE), return on assets (ROA) and stock price, with only 8% showing a negative relationship.
For investment studies focused on risk-adjusted attributes, like alpha or the Sharpe ratio on a portfolio of stocks, 59% showed similar or better performance relative to conventional investment approaches. Only 14% found negative results.
Since this landmark study, the ESG investing market has taken off. The IA collects data on its UK investor members in Financial Conduct Authority (FCA) authorised investment funds and FCA-recognised overseas funds, according to Thomas. Since the IA began tracking these funds in 2000, responsible fund inflows have “tended to be more consistent than non-responsible investment funds” across both retail and institutional markets, she says.
To be classified as a responsible investment fund by the IA, the fund needs to either have specific exclusions, a sustainability focus, or an impact investment strategy. ESG integration alone is not sufficient for inclusion.
To a degree, demand is driven by institutional investors with extended, often inter-generational, time horizons. “Investors often perceive sustainability-focused funds as having longer-term value because they are better aligned with future sustainability trends,” points out Anyve Arakelijan, Regulatory Policy Advisor on Sustainable Finance and ESG at the European Fund and Asset Management Association (EFAMA).
But 60% of respondents to the PwC survey said that ESG investing has already resulted in higher performance yields compared to non-ESG equivalents, with 78% saying they would therefore pay higher fees for ESG funds. The survey included 250 asset manager respondents (US$50 trillion AuM) and 250 institutional investor respondents (US$60 trillion AuM).
This all suggests sustainable investment does not sacrifice returns, even in the shorter term. However, there is evidence to suggest some companies use their public ESG commitments to justify poor financial performance. A 2020 paper published by the University of Northern Iowa and University of South Carolina warned that funds investing in companies publicly embracing ESG are more likely to sacrifice financial returns.
In 2019, University of Chicago researchers analysed the Morningstar sustainability ratings of more than 20,000 mutual funds collectively representing US$8 trillion. Although the highest-rated sustainability funds attracted more capital, none of them outperformed any of the lowest-rated funds from a returns perspective, the paper said.
Further, a 2022 study of 80 European and 64 US funds did not reveal any statistically significant difference between ESG and non-ESG funds across alpha, Sharpe ratio, Treynor ratio or excess daily returns, although it did note “slightly higher” returns for some ESG funds.
Another 2020 paper theorises that market prices “may adjust to a new equilibrium integrating ESG considerations”, meaning the discount rate for highly rated ESG companies will fall, while rising for low rated ESG companies.
“Once the market is in equilibrium, the value of highly rated ESG stocks will be greater, but their expected returns will be lower,” the report said.
Robust or bust?
In this year’s market – characterised by high interest and inflation rates – demand for sustainable investments appears to have proved robust, relatively speaking.
Morningstar’s ‘Global Sustainable Fund Flows: Q2 2023 in Review’ report said global sustainable funds attracted just US$18 billion in net new money for the quarter – just over half the US$31 billion seen in Q1 – due to investor concerns around inflation, rising interest rates and recession. In contrast, the overall global fund universe saw US$37 billion in outflows over the same period, having suffered US$77 billion in outflows in Q1 2023.
“We’ve always said that ESG fund flows are resilient because there is more investor conviction there,” says Hortense Bioy, Morningstar’s Global Director of Sustainable Research.
That doesn’t mean investors should blindly bet on green, of course.
Last year, Morgan Stanley Global Strategy Research assessed how the recent rapid rise in interest rates has impacted bonds and equities.
As long-duration bonds are more sensitive to rising interest rates, the 2022 report noted that investors have favoured short-duration bonds. It added that value also outperformed growth across equity markets. These trends have led to sustainable investment funds underperforming, the report said, as many sustainable investing themes tend to focus on longer-term issues and performance.
For example, when weighting for different style exposures, Morgan Stanley estimated 110bps of the approximate 150bps of sustainable equity funds’ underperformance was driven by their relatively lower exposure to value.
“Sometimes, you will be hard pressed to see clear differences between them [ESG and non-ESG funds],” says Dean Ungar, Senior Analyst at Moody’s Investors Service.
“Claiming that all ESG funds outperform non-ESG funds isn’t a legitimate claim to make. It depends on the fund. It depends on its objective. It depends on the fund manager. Performance is mixed,” he says.
Searching for meaning
But when there are political and regulatory pressures on sustainable fund providers to justify inputs and outcomes, their financial returns to beneficiaries will remain under scrutiny. Clear answers are hard to find, however, due to the many difficulties comparing and defining the ESG fund universe versus the non-ESG fund universe.
The NYU Stern and Rockefeller AM paper highlighted the challenges of comparing all the different findings, noting inconsistent terminology, insufficient emphasis on material ESG issues, ESG data shortcomings, and confusion regarding different ESG investing strategies.
“There’s a whole can of worms when you ask: What is an ESG fund?” says Dewi John, Head of Research for UK and Ireland at LSEG Lipper.
“If you slightly tweak your criteria for a sustainable fund, you can get very different results, both in terms of financial performance and flows.” Despite a plethora of taxonomies, defining an ESG investment remains a problem, he adds.
Attempting to categorise a fund as ESG or non-ESG is far from simple, according to Chris Fidler, Senior Director of Global Industry Standards at the CFA Institute.
“You have to look at several different aspects and none will be determinative on their own,” he says.
“For starters, what is the fund name? What about the investment objectives, investment and engagement strategies, and marketing materials?”
This becomes more of an issue the further along the ‘light green’ end of the sustainable fund spectrum you travel, where justifications for the green label can sometimes become rather tenuous.
“There are some who would consider a fund that merely excludes the energy sector as an ESG fund,” says Rumi Mahmood, Research Director at MSCI Sustainability Institute.
A previous article by John from LSEG Lipper pointed to the inclusion of oil and gas in ESG funds using ‘best-in-class’ screens. Four equity global income funds sold in the UK that are categorised as Article 8 under the EU’s Sustainable Finance Disclosure Regulation (SFDR) have invested more than 10% in oil and gas companies, he wrote, adding that the MSCI World Index has slightly less than 5%.
This exposure will have helped to prop up the performance of these funds when the energy crisis hit and prices soared.
As highlighted by Aviva Investors, the energy crisis prompted the energy sector to outperform all others in 2021, with MSCI World Energy Index up 42% by the end of that year – 19 percentage points more than MSCI World. In contrast, the MSCI Global Environment Index underperformed MSCI World, managing a return of 16.7%.
But the inclusion of carbon-intensive sectors like oil and gas to drive financial performance cannot be easily defined as sustainable – some invest for the sake of supporting the climate transition, while others are sceptical of the sector’s claims that it wants to change for the better.
“ESG doesn’t necessarily mean no – or even lower – oil and gas exposure,” says John.
In comparison, ‘dark green’ renewable energy funds suffered US$1.4 billion in outflows between July to September this year, due to higher interest rates and material costs.
“Renewables-focused funds have seen significant outflows, but you would expect a lot of institutional money – particularly from asset owners like pension funds – to remain invested, given their long-term investment horizons, which are much more aligned with the clean energy transition,” says John.
The fact remains that inconsistencies in the definition of an ESG fund makes one-to-one comparison incredibly challenging.
Cara Williams, Global Head of ESG and Sustainability at investment consultancy Mercer, points out that almost every asset manager has its own framework, “which makes it very difficult as a consultant – and certainly as an investor – to really compare apples to apples when they are all using their own interpretations”.
Mahmood from MSCI adds that sometimes there simply isn’t a non-ESG fund equivalent to compare to an ESG fund, from a performance perspective.
“If you want to compare a fund focused on clean water, it’s not as if there is an unclean water fund out there,” he says.
Instead, analysts typically pit a broad-based market benchmark against the clean water fund, which is far from a perfect comparison.
“Research has always differed, but the underlying logic is that when ESG is part of a fund manager’s due diligence, they will be more aware of the negative shocks to holdings within the portfolio than fund managers who don’t consider ESG, and that should have a long-term benefit,” says John.
Leading by example
The best way to standardise the definition of and the thresholds for an ESG fund is through regulation – a process which has largely been led by the EU.
The EU’s environmental taxonomy, although not yet complete, offers investors some much-needed clarity on the kinds of investments that can be considered sustainable across its six environmental objectives.
The bloc’s Platform on Sustainable Finance (PSF) is now in the process of seeking to fill any gaps industry thinks the taxonomy is currently missing, such as transition activities.
From 2025, EU-based companies will be subject to sustainability reporting requirements under the Corporate Sustainability Reporting Directive (CSRD), thus providing investors with the relevant information they need to determine whether a prospective investee company is sufficiently aligned with the sustainability-related priorities of their funds.
One of the most pivotal – and hotly debated – pieces of regulation, however, is SFDR, which is currently subject to a review by the European Commision.
“SFDR has put mandatory disclosures in place with the intention of making it easier for investors to compare ESG-related performance and cater to investor preference,” says EFAMA’s Arakelijan.
Originally set out as a disclosure framework to provide more transparency of sustainability-focused investment vehicles, the Article 8 (environmental and/or social characteristic) and 9 (environmental and/or social objective) categories have become de facto labels across the sustainable fund universe.
However, prior to the introduction of Level 2 rules for SFDR at the beginning of this year, which require more comprehensive disclosures to justify the categorisation of funds, many fund managers downgraded their Article 9 funds to 8, due to concerns they may be accused of greenwashing.
Further, the distinctions between Article 8 and 9 funds compared to non-ESG funds have long been blurred, with the European Supervisory Authorities (ESAs) seeking clarity from the Commission on what is meant by a ‘sustainable investment’ under SFDR.
Earlier this year, the Commission declined to clarify what is meant by ‘sustainable investment’, noting that it is important entities are transparent in their justifications for sustainability-focused investments.
This demonstrates the extent to which policymakers and regulators play a crucial role in ensuring investors feel supported in their sustainability-related ambitions. Any uncertainty can impact flows into ESG funds.
Morningstar data published in October noted that investors withdrew €20.5 billion (US$21.7 billion) from Article 8 funds in Q3 of this year after redeeming €21.5 billion in the previous quarter. Article 9 funds also hit a “new low”, attracting €1.4 billion in the last three months.
A more dramatic example is the outflows seen in US ESG funds following the onset of the anti-ESG movement. For some, this increases the importance of better defining sustainable investments and demonstrating their value.
“There is growing concern among some US asset managers that investing in ESG funds could have financial implications, with a number of states arguing that there’s no concrete evidence that ESG funds outperform,” says Ungar from Moody’s.
Despite political and economic uncertainty across jurisdictions resulting in quarterly outflows, by and large, institutional investors remain committed to investing in ESG and sustainability-focused funds, according to Mahmood from MSCI.
“It’s not necessarily the case that their appetite [for ESG funds] has increased or diminished, but it has evolved,” he says.
“Institutional investors are closely watching regulatory and market developments – they want to be compliant, they want to avoid greenwashing, and they want to make a positive difference.”
Beyond financial performance, the “crux” of the issue should be determining whether ESG funds are actually making enough of an impact to be called ESG funds in the first place, says Aeby from RepRisk.
“In the end, it’s about having a purpose or not having a purpose, respectively being able to measure that purpose in meaningful ways, which can only be done by adopting impact-based metrics that account for the impact side of double materiality,” he says.
“Without such metrics, investors may lack a clear understanding of the true ESG compliance of their investment strategies.”