Inflows into ESG (environmental, social, governance) funds may have decelerated recently, but the asset class’s long-term prospects are still strong.
First published in Investment Week June 2023.
ESG faces a temporary capital raising blip
According to our latest Fund Flow Index (FFI) figures, ESG funds in the UK suffered their worst month on record in May 2023, losing £300m.
Inflows into ESG funds are slowing down for several reasons.
Firstly, ESG funds did not deliver positive returns last year, with Bloomberg noting that the 10 largest ESG funds by AUM (assets under management) reported double digit losses, with eight of them underperforming the S&P 500, which fell by 14.8%. [1]
This disappointing performance stems from the fact that many ESG portfolios are weighted heavily in favour of technology stocks, which incurred steep losses following the sharp rise in interest rates. Compounding matters further is that shares in fossil fuel companies – owing to the ongoing war in Ukraine – have rallied, prompting some investors to think twice about the merits of buying ESG funds.
Investors have also been deterred from allocating into ESG funds following allegations of greenwashing at certain asset managers. Greenwashing has become increasingly entrenched in asset management circles, a result of fragmented and inconsistent ESG regulations, industry standards and ratings. All of these problems have been exacerbated by underlying ESG data quality issues.
Do not underestimate the resilience of ESG
Despite these challenges, ESG funds should not be written off.
In fact, FFI data shows that ESG equity funds proved highly resilient during last year’s volatility, attracting $8.2 billion in new investor capital – whereas non-ESG funds saw outflows totalling $21.5 billion.
Additionally, the long-term prospects for ESG funds also look promising. Irrespective of the tough headwinds in 2022, the historical performance of ESG funds – when benchmarked against their non-ESG peers – has been strong. For example, Morningstar research conducted in 2020 revealed that ESG funds had outperformed non-ESG funds over the previous three, five and 10 years. [2]
If long-term performance is strong, then investors will incorporate ESG funds into their portfolios.
Greenwashing: The Regulators turn the screw on bad actors
Global regulators are starting to take decisive action against greenwashing, a move which is being welcomed by investors.
So what is happening?
Conscious that investor trust in the ESG market appears to be waning, regulators have successfully penalised a number of financial institutions – including asset managers – for greenwashing offences.
In addition to several investment firms being fined for poor ESG practices, the asset management arm of one major European bank was raided by prosecutors following greenwashing allegations, while a leading UK bank had its climate-related adverts banned, as they were seen to be misleading. [3]
Penalties and sanctions imposed by regulators against financial institutions for greenwashing offences will hopefully discourage organisations from exaggerating their ESG credentials, paving the way for investor trust in the market to return.
Regulations as a means to supporting ESG investing
Sensible regulations are also being drawn up to stamp out greenwashing.
The UK’s Financial Conduct Authority (FCA) – through its Sustainability Disclosure Requirements (SDR) is proposing a robust new labelling regime for investment products. Under the provisions, investment funds will be given the following designations- sustainable focus (i.e. products that invest in assets which could be considered ‘sustainable’); sustainable improvers (i.e. products investing to improve the sustainability of assets); and sustainable impact (products investing in solutions to environmental or social problems). [4]
This should help make it easier for investors to select their preferred funds based on sustainability criteria. The FCA is also looking to further minimise the risk of greenwashing, by demanding managers provide clear information about their sustainability objectives to clients. [5]
Elsewhere, the UK regulator has put index providers and ratings agencies on notice that they could be subjected to greater oversight, amid concerns that their opaque ESG methodologies may be facilitating greenwashing. [6]
Index providers – including MSCI – are responding to this regulatory threat by narrowing their criteria for what qualifies as an ESG fund. The Financial Times is reporting that the number of European exchange traded funds (ETFs) with a designated triple A ESG rating from MSCI is expected to fall from 1,120 to 54, while the number of ETFs with no rating at all will rise from 24 to 462. [7]
In the EU, regulators are expected to make revisions to the Sustainable Finance Disclosure Regulation (SFDR), a piece of legislation which has elicited heavy criticism from the industry.
Under SFDR, funds can classify themselves as being one of either Article 6, 8 or 9 depending on their sustainability objectives.[8] In contrast to the UK- which is proposing stringent classification requirements for funds calling themselves sustainable, the labelling criteria for Article 8 and 9 funds under SFDR are much looser, [9] which has created a fertile environment for greenwashing.
Positive amendments to the SFDR and the introduction of intelligent, proportionate regulations elsewhere could help stimulate investor interest into ESG fund products moving forward.
It is time to standardise the standards
One of the biggest barriers facing ESG is that investors are being totally overwhelmed by industry standards, which are often duplicative and riddled with inconsistencies.
A study by Duff & Phelps revealed 45% of valuation experts believed the absence of a standardised measurement system was a major impediment to ESG disclosure, highlighting that respondents are often using multiple ESG frameworks when reporting on ESG. [10]
Without a single standard, it is difficult for asset managers and issuers to report accurately on their ESG, much to the detriment of investors. However, the industry does appear to be making headway on ESG standardisation.
The International Finance Reporting Standard’s (IFRS) International Sustainability Standards Board is in the process of establishing the Sustainability Disclosure Standards (SDS), which is consolidating a number of existing principles – including the Taskforce on Climate Related Disclosures and the Sustainability Account Board standards – into a single framework. [11]
The framers of the SDS are also liaising with leading regulators, so as to ensure that the SDS are incorporated into current ESG rules, and used to shape future regulation. [12]
If a common standard can be established, it could help eliminate a lot of the confusion that surrounds ESG, in what will be a positive development for investors.
A market that is moving in the right direction
Investor allocations into ESG funds may have lost some momentum, but the asset class is in a good place. In addition to solid long-term performance, many of the barriers inhibiting ESG fund growth are being gradually removed through the introduction of intelligent regulations, and the adoption of a harmonised industry-wide standard.
As the market matures, investor flows will swiftly follow once again.
[1] Bloomberg – December 7, 2022 – Big ESG funds are doing worse than the S&P 500
[2] Financial Times – June 13, 2020 – Majority of ESG funds outperform wider market over 10 years
[3] ESMA – February 2023 – TRV Risk Monitor
[4] PwC – October 2022 – FCA proposes new rules on UK SDR , labelling and greenwashing
[5] PwC – October 2022 – FCA proposes new rules on UK SDR , labelling and greenwashing
[6] Financial Times – March 22, 2023 – UK regulator takes aim at index providers over greenwashing
[7] Financial Times – March 24, 2023 – Hundreds of funds to be stripped of ESG rating
[8] Morningstar – February 2, 2023 – ESG fund downgrade accelerates
[9] Funds Europe – April 3, 2023 – Report: Commission considering scrapping Article 9 Label
[10] Private Equity Wire – July 6, 2021 – Lack of standardised ESG reporting system biggest threat to effective ESG disclosures, says Duff & Phelps
[11] Sustainalytics – April 4, 2023 – What the upcoming ISSB standards mean for corporate reporters and issuers
[12] Sustainalytics – April 4, 2023 – What the upcoming ISSB standards mean for corporate reporters and issuers
