If the turning point for environmental, social and governance (ESG) funds isn't here yet, it's getting close. Last year was a banner setup for ESG funds on multiple fronts, including where it matters most: Performance and asset gathering. Broadly speaking, ESG funds topped their traditional rivals in 2020.
“After holding their own in the fourth quarter, sustainable equity funds finished 2020 with a clear performance advantage relative to traditional equity funds,” writes Morningstar analyst Jon Hale. “Sustainable funds are those that emphasize the use of environmental, social, and governance criteria to generate financial return and broader societal impact. For most of the year, the kinds of stocks that sustainable equity funds prefer–those of companies with better ESG profiles and that are aligned with the transition to a low-carbon economy–outperformed.”
Then there are the inflows. Last year, ESG funds hauled in a jaw-dropping $51.1 billion in fresh assets. That was more than double 2019's total of $21.4 billion. Further underscoring the impressive pace of inflows to ESG funds is that advisors and investors added just $5.4 billion to the products in 2018 and that was a record at the time.
Repeating or topping that feat this year may appear difficult, but consider this: Asset allocators' affinity for open-end ESG funds accelerated late in 2020 with $20.5 billion of that $51.1 billion arriving in the fourth quarter. That says sustainable funds enter 2021 with considerable momentum.
ESG Flows Still in Early Innings
Market observers and sustainable investing experts see multiple tailwinds for ESG investments as 2021 unfolds. As noted above, last year, ESG funds resoundingly answered one of most lingering, pressing concerns: Ability to outperform standard equity funds.
“In 2020, ESG indices outperformed their non-ESG counterparts,” said State Street Head of Practice Management Brie Williams and Equity ETF Strategist Rebecca Chesworth. “Compared with the S&P 500 Index, the S&P 500 ESG and S&P ESG Exclusions II indices achieved ~1.5% outperformance, with less volatility of returns.”
The ability of ESG strategies to deliver superior risk-adjusted returns is an obvious selling point for asset allocators and highlights ESG's correlation to the quality factor. That factor typically remains persistent over time, indicating that sustainable strategies' ability to trim volatility is, well, perhaps sustainable.
Another catalyst for increasing ESG adoption is that companies are increasingly aware that being more attentive to the needs of employees, clients and society at large is a winning long-term value proposition. To that end, more global firms are voluntarily boosting ESG disclosures and guidelines.
“Although ESG investing is not mandatory, global regulators and policymakers have published increasingly strict guidelines to ensure that asset managers who incorporate ESG considerations into their investment strategies can provide end investors with a transparent understanding of their methodology,” according to State Street. “For example, the United Nations-backed Principles for Responsible Investment (PRI) now requires its signatories to adopt mandatory climate-related financial disclosures, or face loss of their accreditation.”
Owing to the fluidity often applied to the “S” and “G” in ESG and the chances for political implications to arise from those factors, companies often emphasize the “E.” It's a practical approach on the basis of efficiencies, cost savings and because the climate crisis is an issue that resonates with a variety of stakeholders.
“The PRI lists climate change as the biggest risk faced by investors, citing physical and transition risks to portfolios. And Task Force on Climate-related Financial Disclosures (TCFD) on the governance of climate risks and their strategic impact became compulsory for PRI signatories last year,” notes State Street.
More companies are getting hip to the fact that customers and investors want to do business with firms viewed as sound environmental stewards. As that trend evolves, and it almost assuredly will, advisors will have more conversations with clients about the virtuous of sustainable investing, sending more capital in to the related funds in the process.