Fund shops focused on ESG despite pushback, reports show

It’s a tough time to be sustainable funds shop, as political backlash and performance drags have put the sector in an unwanted spotlight.

Yet asset managers are sticking to their guns — or at least their gun-free investment strategies.

According to reports this week from Cerulli Associates and ISS, U.S. fund companies continue to see potential in ESG, with many expanding their product range and staffing up to support it.

“Fears of negative returns and the perception that performance may be sacrificed in the name of ESG/ sustainability continue to be a major challenge to firms when it comes to marketing their strategies. Managers will need to be prepared to confront ebbs and flows in demand when it comes to ESG allocations,” according to Cerulli’s new Global State of ESG paper. “However, across many regions around the globe, firms polled by Cerulli over the past year generally did not exhibited plans to backtrack on product development, sales, or marketing of ESG products.”

Well over half (58%) of asset managers said in 2022 that incorporating ESG criteria into investment products and processes was a high priority, while another 35% indicated it was a moderate priority. That's down from the 81% of firms that described ESG as a high priority in 2021, but the figures last year are nonetheless trending upward from the level of 31% seen in 2018.

Further, two-thirds of asset managers said they are adding staff or resources on ESG, while 56% are focused on building out teams for sustainable fund distribution, according to Cerulli. Fifty-four percent are also increasing head counts for portfolio management related to ESG, and nearly as many, 53%, are doing so for “active ownership,” or the engagement that managers have with their portfolio companies. Additionally, half are hiring up for ESG risk management, and 44% are doing so for product development.

“If interest in ESG is about to crater, someone forgot to tell fund managers, who continue to launch new ESG products at a healthy pace,” the report today from ISS noted. “All in all, 89 new ESG strategies debuted last year — falling short of the record 133 launches in 2021, but still well ahead of 2019 and 2020 levels.”

That report also points to the stronger relative sales of ESG-themed funds last year compared with the broader range of U.S. mutual funds and ETFs, reaching a similar conclusion that Morningstar did in a report earlier this year: Despite all the recent challenges around ESG, investors apparently are still interested in sustainable funds. Sustainable funds raked in over $3 billion, while the broader universe of funds and ETFs saw net outflows of $370 billion, according to Morningstar.

But what might be even more telling about the use of ESG is how it's being incorporated into products that aren't outwardly focused on sustainability. While it’s become common for mutual funds and ETFs to include language around ESG considerations in their prospectuses, funds that don’t examine such criteria at all might soon be in the minority.

The analysis by ISS found $1.9 trillion in fund assets last year moved to include ESG considerations.

“The lion’s share came in the first quarter when behemoth manager American Funds disclosed it would include ESG factors as part of the investment process firmwide — making it the largest fund manager in the U.S. to do so,” the ISS report noted.

Much of the reason that sustainable funds eked out positive net sales last year was new money, and that might not bode well for sales going forward, the ISS paper said.

Since 2020, an estimated one-third of sustainable fund sales have been “flows originating from outside the fund ecosystem,” according to ISS. “The unique, pandemic-driven circumstances behind the surge in exogenous flows are unlikely to repeat, presenting ESG funds with a more challenging environment for growth.”

However, the customer base likely “has not been maxed out,” and most sustainable fund investors have tended to view the products are accessories rather than core portfolio holdings, the report noted. As products proliferate and represent a wider range of asset classes, that could change.

In particular, sustainable fund investors have been underrepresented in fixed income, the report noted. While 63% of ESG-themed fund allocations in 2022 were to U.S. equity, just 1% was in taxable bonds and 15% in tax-free bonds. By comparison, the broader U.S. fund market had 56% in U.S. stocks, 4% in taxable bonds and 21% in tax-free bonds.

Sustainable funds were overrepresented in international equity, at 21% of allocations, compared with 17% of the broader fund market.

But an area with a massive but untapped potential for growth is the defined-contribution plan area, which thanks to a new Department of Labor rule is now open to sustainability-themed default investment options such as target-date funds.

Assets in ESG-themed funds in DC plans reached $11.4 billion in 2021, up from $6.7 billion in 2019, ISS found. However, the 2021 figure represented just 0.5% of all plan mutual fund assets.

While there are few target-date products on the market for that niche, asset managers such as Natixis, BlackRock and Putnam have been rolling out new ones or adapting their existing ones in anticipation of the DOL’s new stance on ESG.

Likely there will be more entrants, given firms’ overall focus on sustainability.

“About nine out of 10 U.S.-based asset managers have made ESG considerations a part of their firms’ mission and culture,” the Cerulli report stated. “Similarly … 93% of U.S.-registered mutual fund and ETF assets are affiliated with a UN Principles for Responsible Investment signatory — although not all of these assets take ESG considerations into account.”