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Portfolio > Portfolio Construction > ESG

ESG Funds Outperform in Growth and Returns in 2018: Morningstar

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The number of sustainable investment funds has increased nearly 50% in the past year to 351, with total assets of $161 billion by the end of 2018, according to a new paper by Morningstar. A record number of those were launched in 2018 and more existing funds added environmental, social and governance criteria to their prospectuses, according to Jon Hale, director of sustainability investing research, who wrote the paper. In fact, there were 37 new funds launched last year, while 63 existing funds added ESG critieria.

This was surprising to Hale, who told ThinkAdvisor that the “flows continued to be strong relative to their past even during a year when overall fund flows were the worst they had been since the financial crisis.”

Thus, despite the unfavorable market conditions in 2018, sustainable funds attracted record net flows of $5.5 billion. In fact, it was the third consecutive year of record flows. Hale notes in the paper that positive sustainable net flows stand “in contrast with the overall U.S. fund universe, which netted its lowest calendar-year flows since 2008. Stock market returns in 2018 were the worst since 2008, and bond market returns were the worst since 2013, yet both ESG equity and bond funds garnered positive net flows.”

More remarkable, or perhaps not, was the performance of sustainable funds. Hale found that 63% of sustainable funds finished in the top half of their respective categories in 2018.

He also found that over the past three years the number of new sustainable funds has neared parity with open-end funds. According to the paper, 28 of the new fund launches were equity funds while nine were bond funds.

Some of the new funds targeted specific areas. For example, after the Parkland High School mass shooting, BlackRock launched an optimized ETF to “provide small-cap investors with a guns-free passive option where none existed before,” Hale wrote. (ESML was launched in April 2018 and currently has $19.6 million in assets.) Other firms, notably Vanguard, launched two ETFs that screened out nonrenewable energy, vice products and weapons but did not “broadly incorporate company ESG metrics into portfolio construction.”

IShares took two-thirds of all net flows for ESG-focused ETFs, with 13 funds that attracted more than $1.5 billion in net flows, according to Morningstar.

Other findings of the paper included:

  • Passive ESG funds attracted the most flows. Of the top 10, only the top two were actively managed.
  • Sixty-two funds added ESG as a criteria to their prospectuses, with 11 of those “completely repurposed into sustainable funds and renamed to reflect their makeover.”
  • International offerings in sustainable funds grew dramatically, including those in emerging markets and foreign large-cap funds.

Hale also developed a taxonomy around the 351 funds, which are:

1. ESG consideration, which is a fund that “uses ESG information to help inform its investment decisions, and that has formalized its ESG consideration by noting it in the fund’s prospectus.” These are becoming more common, Hale notes, as a “recent survey of asset managers conducted by Harvard Business School professors showed that more than 80% now consider ESG criteria when making investment decisions and do so, not only because of growing client demand but because they believe ESG information is material to investment performance.’”

“Some people kind of shake their head at that like it’s not a big commitment,” Hale told ThinkAdvisor. “But when a fund puts something in their prospectus, that have to be ready to defend it potentially in an SEC audit.” He sees the trend of large funds moving toward ESG continuing.

2. ESG Integration, which are the most common funds, and “broadly integrate ESG criteria throughout their investment processes.” Hale sees these fund moving more toward impact funds to “distinguish” them more from consideration funds, “but also partly to respond more directly to client/investor demand, [those who] want funds that provide some measure of impact beyond financial demand,” he says.

3. Impact, which are defined as “investments made into companies, organizations and funds with the intention of generating social and environmental impact alongside a financial return.” Hale notes that more funds are moving this direction.

4. Sustainable sector, which are funds that focus “on ‘green economy’ industries like renewable energy, energy efficiency, environmental services, water infrastructure and green real estate.” These funds can be the most volatile, he says, as any type of focused funds can be.

Hale adds that although investors are told to invest in the lowest cost market-based index funds, “these are not neutral investments.” These indexes can include manufacturers of guns or non-ESG stocks, and the sheer volume of money that goes into these indexes can mean a significant portion goes to these stocks. ESG ETFs or indexes, he says, also can be low cost and make a difference.

“[Investors] are going to find that you can invest in climate-aware ways that make sense, and may be more impactful than practically anything else an individual can do on that front,” Hale says.

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