ESG funds flows sank 2022 to their lowest level in 7 years and that for good reasons

Not sure if you heard the news, but the EU passed ESG regulation which went into force in January this year. If you think this doesn’t apply to you, think again. The provisions in the ESG regulation could very much apply to suppliers and consumers around the world.

Watch the video below to understand better why.

Not surprisingly, the EU’s ESG push came at the start of the pandemic, which is the same time that Blackrock CEO Larry Fink published an open letter telling the CEOs of all the companies the asset manager is investing in to comply with ESG criteria, or else.

Since then, we’ve seen no shortage of ESG initiatives, but almost all of these have come from the private sector.

The EU’s ESG regulation is the first initative from the public sector, and it’s being described as ambitious by its biggest fans.

(Video: ESG regulations are here. How they will affect you)

ESG FUND FLOWS CRASHED IN 2022

Flows into U.S. sustainable funds have fallen steadily since their record US$21.5 billion haul in the first quarter of 2021.

Although U.S. sustainable funds ended 2022 in positive territory, their US$3.1 billion net annual inflow was ‘dimensions ‘below the average US$47 billion annual collection these funds had enjoyed over the previous three years.

First of all, ESG funds certainly perform fundamentally poorly in financial terms.

In a recent Journal of Finance paper, the University of Chicago researchers analyzed the Morningstar sustainability ratings of over 20,000 mutual funds representing over US$8 trillion of investor savings.

Although the highest-rated funds in sustainability attracted more capital than the lowest-rated funds, none of the high-sustainability funds outperformed any of the lowest-rated funds.

That result might be expected, and it is possible that investors would be happy to sacrifice financial returns in exchange for better ESG performance. Unfortunately, ESG funds don’t seem to deliver better ESG performance either.

Researchers at Columbia University and the London School of Economics compared the ESG record of U.S. companies in 147 ESG fund portfolios and U.S. companies in 2,428 non-ESG portfolios.

They found that the companies in the ESG portfolios had worse compliance records for both labor and environmental rules.

They also found that companies added to ESG portfolios did not subsequently improve compliance with labor or environmental regulations.

This is not an isolated finding.

A recent European Corporate Governance Institute paper compared the ESG scores of companies invested in by 684 U.S. institutional investors that signed the United Nation’s Principles of Responsible Investment (PRI) and 6,481 institutional investors that did not sign the PRI during 2013–2017.

After signing, they detected no improvement in the ESG scores of companies held by PRI signatory funds.

Furthermore, the financial returns were lower and the risk higher for the PRI signatories.

Why are ESG funds doing so poorly?

Part of the explanation may be that an express focus on ESG is redundant.

In competitive labor and product markets, corporate managers trying to maximize long-term shareholder value should pay attention to employee, customer, community, and environmental interests.

On this basis, setting ESG targets may distort decision-making.

There’s also some evidence that companies publicly embrace ESG as a cover for poor business performance.

A recent paper by Ryan Flugum of the University of Northern Iowa and Matthew Souther of the University of South Carolina reported that when managers underperformed the earnings expectations (set by analysts following their company), they often publicly talked about their focus on ESG.

But when they exceeded earnings expectations, they made few, if any, public statements related to ESG.

Hence, sustainable fund managers who direct their investments to companies publicly embracing ESG principles may be over-investing in financially underperforming companies.

The conclusion drawn from this evidence seems pretty clear: funds investing in companies that publicly embrace ESG sacrifice financial returns without gaining much, if anything, in terms of furthering ESG interests.