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Sustainable Investing Sees Record Flows, Outperforms Peers

ESG Investing

Sustainable investing apparently is starting to hit on all cylinders for U.S. fund investors, as funds not only saw record flows for the fifth year in a row, but in many cases outperformed their peers.  

According to new research by Morningstar, sustainable funds attracted a record $51 billion in net flows in 2020, more than twice the previous record set in 2019. In “Sustainable Funds U.S. Landscape Report,” the firm also reports that sustainable fund flows accounted for nearly one fourth of overall net flows into stock and bond mutual funds in the U.S. in 2020. 

Sustainable funds also “comfortably outperformed” their peers in 2020, especially equity funds. The firm found that three of every four sustainable equity funds finished in the top half of their Morningstar Category, and 43% posted top quartile returns. By contrast, the returns of only 6% landed in their category’s bottom quartile. 

“The reasons for the outperformance are varied because ... sustainable funds do not all take the same approach. The characteristic they do share is that they put the evaluation of ESG concerns at the center of the investment process in their evaluation of securities, portfolio construction, and societal impact,” writes Jon Hale, Morningstar’s Director of Sustainable Investing Research and author of the report. 

Sustainable investing generally refers to the full consideration of environmental, social and corporate governance (ESG) concerns within an investment strategy, both to enhance investment performance and contribute to better societal outcomes, the report explains. 

Record Flows

Amid high levels of interest in sustainable investing, several key factors contributed to the record flows, according to the research. One is that the growth of sustainable funds since 2015 has given investors an increasing range of options from which to select, allowing investors to identify sustainable fund choices more easily and build out their portfolios. 

In fact, the number of sustainable open-end and exchange-traded funds available to U.S. investors increased to 392 in 2020, up 30% from 2019, the research found. Furthermore, this group of funds has experienced a nearly fourfold increase over the past 10 years, with significant growth beginning in 2015.   

A second factor is that lingering doubts about underperformance have diminished as more sustainable funds build competitive performance records. “This is an especially important factor for intermediaries and advisors who do not want to steer their clients into underperforming investments,” the report emphasizes.  

More investors wanting to have a positive impact on the world is a third key factor contributing to flows into sustainable funds. “The turbulent events of 2020—the global coronavirus pandemic, continued weather extremes, the movement for racial justice in the United States, and the U.S. presidential election—underscored the salience of sustainability concerns to investment managers and strengthened the rationale for end investors to invest in a sustainable way,” Hale observes. 

As such, the basic consideration of ESG issues to enhance investment performance has become widespread even among traditional investment managers, who are beginning to recognize the materiality of ESG risks and opportunities in security selection, the report observes. 

While just two years ago it was uncommon to find any reference to ESG in the offering documents of traditional funds, many funds now indicate in their prospectuses that they may consider ESG factors at some point in their investment process, the report explains. “We expect that virtually all funds will soon be routinely explaining in their prospectuses the role ESG plays in their investment process, regardless of how central it is,” says Hale. 

And while the Morningstar report doesn’t specifically address the prospects for ESG investing in retirement plans, many industry observers believe that ESG investing will increasingly work its way onto DC plan investment menus, regardless of whether the Biden administration eventually seeks to rewrite the Trump-era Department of Labor rule to ease some of the requirements for considering ESG investments. 

Shortly after taking office, President Biden signed an executive order calling for a review of environmental actions taken by the Trump administration, including the DOL’s guidance addressing “Financial Factors in Selecting Plan Investments,” which became effective Jan. 12, 2021. The final rule pulled back from some of the more stringent requirements outlined in the proposal, but arguably was still implicitly directed at ESG investing.