US sustainability funds just faced their worst year on record in 2023, according to a new Morningstar report, but the outlook isn't entirely bleak.

In the fourth quarter, investors withdrew $5 billion from sustainable open-end and exchange-traded funds (ETFs), marking the fifth straight quarter of net outflows, according to the report. Throughout 2023, investors pulled $13 billion from US sustainable funds, more than offsetting positive flows in Europe and dragging down the market globally. That made 2023 the worst calendar year on record for these funds since Morningstar began tracking them more than a decade ago.

Alyssa Stankiewicz, associate director of sustainability research at Morningstar, said the macroeconomic environment drove much of the weakness. Global supply constraints, Russia’s invasion of Ukraine, and high interest rates coalesced to make clean energy companies less profitable.

At the same time, political scrutiny — particularly over "greenwashing" — and a lack of clear regulation across jurisdictions created a "chilling effect" on demand, Stankiewicz added.

"We're at a bit of an inflection point within the sustainable investing landscape in the US, where it's really incumbent upon sustainable investing advocates to be very clear about what they're doing within their investment processes to regain investor confidence in the sector," Stankiewicz told Yahoo Finance.

Sustainable funds see waning demand as ESG matures

The rough period for sustainable funds has been notable given the massive growth of these funds in recent years.

The amount invested in US sustainable funds — which encompasses a variety of investment approaches that feature environmental, social, and governance (ESG) risk frameworks and other socially responsible criteria — totaled $323 billion by the end of 2023, 12% lower than the record amount invested in 2021.

"We saw such strong inflows between 2019 and 2021," Stankiewicz said. "It's not as though all of those investors that started allocating to sustainable funds are all of a sudden running for the exits."

A significant portion of the outflows in 2023 came from one fund: the iShares ESG Aware MSCI USA ETF (ESGU). A change in BlackRock’s (BLK) target-allocation ETF portfolios early on in 2023 led investors to yank $9 billion from that fund, whose top holdings include Apple, Microsoft, Alphabet, Amazon, and Nvidia, in favor of another.

Sustainable investors, like investors broadly, also demonstrated their preference for passive funds over active ones. While they unloaded from both active and passive funds in Q4, actively managed funds made up about 90% of the outflows ($4.6 billion).

Yet lackluster returns were perhaps the most prominent reason investors dumped sustainable funds. Their performance improved from 2022's lows, but they still lagged behind their traditional peers.

While sustainable bond funds went toe-to-toe with their peers in the fourth quarter, sustainable equity funds fared worse. The median sustainable large-blend equity fund gained 20.8% in 2023, while all funds — sustainable and conventional — notched a 23.9% gain for the year.

The underperformance of ESG-focused funds strikes at the heart of a core argument of ESG: that investors are rewarded by investing in do-good companies. Proponents of ESG argue that it provides a framework for evaluating environmental, social, and governance risks that other funds don't take into consideration, leading to more durable value over time.

And over time, that thesis may still hold. With over 110 nations pledging to triple renewable capacity by 2030, the transition to green energy poses "a long-term driver" for many environmentally focused investments, Stankiewicz said. But the transition has proven to be anything but smooth as near-term shocks hinder progress.

On some level, the recent waning enthusiasm for sustainable funds may also demonstrate their mainstream adoption. Politicians are debating over "wokeness" and ESG, sustainable funds are expanding into new asset classes, and companies are finding new ways to talk about ESG while avoiding saying the word.

Through it all, though, the underlying principles of ESG are being picked up by asset managers who aren't using sustainability labels.

"I think it's almost because the consideration of those [ESG] factors has become so ubiquitous that investors don't necessarily see the need to select funds that are instituting binding criteria around environmental and social factors," Stankiewicz said, "because they have good alternatives in funds that are managing for financial materiality."

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