Investors Are Ditching ESG-Focused Funds, But They Might Be Missing A Trick

Investors once flung themselves into funds focused on environmental, social, and corporate governance (ESG) factors, perhaps swayed by the idea of making the world a better place, and almost definitely enchanted by the prospect of higher returns. But they’re fleeing the scene now that regulators are clamping down on so-called “greenwashing” – and political divide and underperforming funds won’t have helped either. So I’ve dug into the details to work out whether ESG’s just an overpriced label, or exactly what the world and its portfolios have been crying out for.

What’s happening in the US?

Investors have been pulling cash out of ESG-focused exchange-traded funds (ETFs) faster than you can say “climate change”: Bloomberg data shows the iShares Aware MSCI USA ETF (ESGU; 0.15%) – the biggest ESG ETF in the US – has lost nearly one-third of its assets in outflows this year, stripping just over $6 billion from its books.

And no wonder, really, given the divide on political party lines. Republicans consider ESG investing to be "woke" capitalism that prioritizes liberal goals over investor returns, with red states pulling nearly $1 billion from BlackRock due to the firm’s ESG stance. Some Democrats, meanwhile, have slammed BlackRock for not being more focused on ESG issues.

President Biden was even forced to use his first veto to block a Congress-approved bill that would stop fund managers from considering ESG factors when investing. This dispute – and the fear of losing more assets – saw BlackRock CEO Larry Fink omit any ESG references in his recent annual letter, a reversal from previous years.

But it’s not just politicians driving this debate. VictoryShares ETFs – which manages around $8 billion in assets spread across 25 US-listed products – deleted ESG labeling from two of its bond ETFs earlier this year, following in the footsteps of Inspire ETFs after it did the same last year.

Why are ESG funds imploding in Europe?

New regulations for ESG funds have sent the European market into turmoil. See, there are now two main categories for them: Article 9 funds with aims of sustainable investments or reduced carbon emissions, and Article 8 ones that just need to promote environmental or social characteristics. These new distinctions were created with an aim to stop “greenwashing” – that’s unfairly labeling funds as ESG-focused when firms aren’t practicing what they preach.

Shockwaves from the refreshed regulations are already clear. BlackRock, Amundi, and Pictet – three giants of the fund management world – removed the ESG label from €175 billion worth of funds earlier this year, reducing the size of the market by 40%. What’s more, the Financial Times reported that a consultation on MSCI’s ESG ratings will slim the number of European ETFs with a triple-A rating (the highest available) from 1,120 to just 54. In other words, an eye-watering number of ESG-labeled funds seem to have been paying lip service rather than actually focusing on the key issues – and that, folks, is a prime example of greenwashing.

How are ESG funds performing?

At the end of the day, investors care about how assets perform. And when it comes to ESG, there isn’t much to write home about.

Biggest ESG ETFs in the US, expenses and performance. Source: Bloomberg.

The table above shows the biggest ESG-focused ETFs in the US, outlining their performance, expense ratios, and total assets. For comparison, I also included two of the biggest standard ETFs: the Invesco QQQ Trust (QQQ; 0.2%) which tracks the Nasdaq 100 Index, and the SPDR S&P 500 ETF (SPY, 0.095%) which tracks the S&P 500.

You can see that the performance of most of the ESG ETFs is closely correlated with the SPY ETF, which might not be a surprise given that their biggest holdings seem to mirror those of the S&P 500. Just look at the iShares ESG Aware MSCI ETF’s top holdings: Microsoft, Apple, Nvidia, Amazon, and Alphabet.

iShares ESG Aware ETF (white line) and SPDR 500 ETF (orange line) performance. Source: Bloomberg.

So when you compare the iShares ESG ETF to the SPDR S&P 500 ETF on a five-year view, it makes sense that their price moves are virtually the same. And if you’re feeling skeptical, that might make you wonder why you’d pay more for an ESG fund when it simply seems to closely track the S&P 500.

Now in fairness, some funds really do follow stricter investment criteria. You’ll see in the table above that two ETFs, focused on solar and clean energy, managed to produce better (but not stellar) returns, which may well justify their slightly higher charges.