Sustainability Matters

Are Sustainable Investors More Likely to Stay the Course?

First-half flows into sustainable funds suggest the answer may be yes.

Sustainable funds in the U.S. have faced significant headwinds this year. First, it’s been a terrible year for both stocks and bond funds, conventional and sustainable alike. Through June, the Morningstar US Market Index lost 18.8%, the Morningstar Global Markets Index lost 20.2%, and the Morningstar US Core Bond Index lost 10.1%. While things have improved in July, virtually all sustainable funds have negative returns for the year to date.

Second, many sustainable funds have underperformed the market and traditional funds. Their average ranking in their various Morningstar categories through June was 57. That’s below median on a scale of 1–100, with 1 being the best ranking for a fund in a category. (On the other hand, their long-term performance holds up. Despite the poor year-to-date comparison with peer funds, sustainable funds’ average trailing three-year and five-year category rankings, which include the first half of 2022, are an impressive 41 and 39, respectively.)

Third, sustainable investing has been getting more criticism than it has since its real ascent began in 2016. And it has come from several directions. Traditionalist investors point to its first bout of underperformance over the past five years as evidence that it’s not working. They say that investing based on environmental, social, and governance factors, a popular type of sustainable investing, is bound to fail because ESG isn’t really all that material to assessing an investment; or because it shouldn’t be a strategy’s main investment criteria; or because it may exclude bad companies that perform well; or because ESG data is sometimes inaccurate.

Sustainable investing has also faced criticism from those who believe it’s inauthentic for not going far enough to assess the broader impact of investments, and for being more about investment results than generating positive outcomes for people and planet.

And in the U.S., the political Right has recently condemned “ESG” as an attempted leftist takeover of asset managers to force oil companies out of business, push companies of all kinds to focus on diversity, equity, and inclusion, and prod CEOs to take progressive stances on social issues. Several Red states have moved to limit their business and investments with banks and asset managers they perceive as being practitioners of ESG.

In light of all this negativity, you might expect to find that investors have pulled a lot of money out of sustainable funds so far this year. But that has not been the case, at least not compared with funds overall. Over the first half of the year, while funds overall shrunk by 0.4%, sustainable funds grew by 2.5%.

During the second quarter, open-end and exchange-traded funds overall in the U.S. suffered massive outflows of $289 billion. It was the largest quarterly outflow since Morningstar began tracking fund flows in 1993 and only the third time since then that there have been three consecutive months of outflows.

Not surprisingly, sustainable fund flows were also negative in the second quarter, but they held up much better than flows into funds overall. Their modest $1.6 billion outflow for the quarter was proportionately far less than the outflows of funds altogether. Sustainable funds had net inflows in April and June while funds overall had outflows of $90 billion.

Also notable has been the continued secular growth of sustainable bond funds this year. While investors have pulled $294 billion from bond funds this year, they have added $4 billion to sustainable bond funds.

What does all this say about sustainable investing? It suggests, first, that sustainable investors may be more likely to stay the course during tough markets. That’s a hard thing for many investors to do. But perhaps sustainability forges a stronger connection between investors and their investments that keeps them focused on the long term. If investors feel their investments are also seeking to generate positive outcomes beyond investment returns, that’s another reason to stick with those investments when markets go south.

Second, the flows into bond funds suggest investors are growing their commitment beyond stock funds. They are now using sustainable funds to build out their overall portfolios.

Despite the critics, it’s hard to deny that there is widespread interest in applying sustainability to investments. More people today are sustainability-minded and comfortable with considering the broader impact of decisions they make in all facets of their lives — consumer, career, citizen — so it only makes sense that they would also want to approach investing with sustainability in mind.

That’s not to say it’s easy to supply this demand with great investment products. Sustainable funds have to deliver both competitive returns and at least do their part to generate positive outcomes. I think they’ve done this fairly well so far, and investors have responded with flows, but we’re still in the early innings and more improvements and innovation are still to come and should be an expectation of investors.

This article was originally published on Morningstar.com.

Follow me on Twitter @Jon_F_Hale.