Investors moved $1.6 billion out of U.S. sustainable funds in the second quarter, according to a Morningstar report, marking the first quarter of outflows in more than five years.

When compared to the broader market, demand for sustainable funds remained resilient.

"It's worth noting that even though sustainable funds saw outflows, this was less severe than the total U.S. market," Alyssa Stankiewicz, Morningstar associated director of sustainability research in the U.S., told Yahoo Finance. "I do think that this higher level of demand and sustained growth versus the overall market does point to demand for sustainable funds being a bit more sticky, meaning that investors have higher conviction and tend to stick with them even when short-term performance might be a challenge."

The organic growth rate for sustainable funds, calculated as net flows as a percentage of total assets, held up much better than that of the overall market.

In the second quarter, the organic growth rate of the sustainable funds market fell 0.45% compared to a decline of 0.74% in the overall market. And year over year, the sustainable funds market increased by 13% whereas the overall market only grew by 1.4%.

Globally, sustainable funds were buoyed by Europe and captured $32.6 billion in inflows during the quarter, a 62% decline from the first quarter.

How sustainable funds fared

Inflation, rising interest rates, and recession fears played a large role in the decline. The move up in energy prices due to the Russia-Ukraine war and a confidence crisis in assets labeled for their environmental, social, and governance (ESG) virtues likely didn't help.

"Investors are looking at ESG investments as one part of a larger portfolio, and they rebalance or reposition depending on what they're seeing as forward-looking trends to the overall market," Stankiewicz said about investors wanting to reduce risk exposure.

The bear market in stocks challenged active funds and sustainable equity funds in particular.

“The hardest-hit category within our sustainable funds universe was the sector equity category, especially in energy and tech climate funds and renewable energy funds,” Stankiewicz explained. “I think one of the main drivers for that is probably just due to performance. They had overall pretty challenging 2021 and first half of 2022.”

Notably, the picture was rosier for sustainable bond funds as investors sought refuge from inflation. Sustainable bond fund flows as a category continued to see inflows during the quarter, even as traditional taxable- and municipal-bond funds shed $150 billion.

“Sustainable bond funds have been seeing increasing adoption in past quarters — they actually hit a new record in the first quarter with $3.2 billion in inflows,” Stankiewicz said. “During the second quarter, obviously, they were down from that record, but they did stay positive.”

The sustainable funds that saw the most inflows included the iShares ESG Aware MSCI USA ETF (ESGU), Invesco Floating Rate ESG (AFRAX) and the Vanguard ESG U.S. Stock ETF (ESGV). The bottom funds with the most outflows were the iShares ESG Aware MSCI Emerging Markets ETF (ESGE), Parnassus Core Equity (PRBLX), and Calvert U.S. Large Cap Core Responsible Index (CISIX).

Institutional players investing 'in a big way'

Institutional investors appear to be behind sustainable fund market's momentum; Sudden inflow surges point to larger organizations, as was the case with the SPDR MSCI ACWI Climate Paris Aligned ETF (NZAC).

“What was really interesting about this fund is that just in the month of April, that funds gained $149 million in net flows, and that's more than six times the total flows that this fund saw in 2021,” Stankiewicz said. “So that would point to very likely an institutional client coming in for that fund in a big way.”

But institutional investors can also have large effects at the other extreme. After BlackRock changed its recommendations for its Target Allocation ETF portfolio series, the investing giant reduced its exposure to the iShares ESG Aware MSCI Emerging Markets ETF in May, which drove significant outflows. Consequently, that fund saw the most outflows of any sustainable fund in the second quarter, totaling $1.26 billion.

According to another ETF expert, it makes sense that retail investors would suspend deposits into ESG funds while they grapple with the broader market downturn. Though he noted that this would likely only be temporary.

“The evidence would suggest that institutions, which are really the drivers of the assets in the ESG space, they don't seem to be slowing down,” Dave Nadig, a financial futurist at VettaFi, told Yahoo Finance in early July. “What we have seen is a pullback in interest from the average retail investor. I think that's completely understandable.”

Despite the setback in flows this quarter, new investment product launches kept apace with asset managers launching 32 sustainable funds, 12 of which were ETFs and 20 were equity funds.

“It's helpful to remember that a lot of these funds are still very new,” Stankiewicz said. “A lot of them are still coming to market, and many advisers look for three- or five-year track records before they recommend investing in a fund. They also look for a certain asset base before they recommend investing in a fund.”

She added: “In light of the fact that so many of these funds are still new, I think the prospects for continued growth in this sector are still pretty strong, especially given what we're seeing in the early stages of the market.”

Grace is an assistant editor for Yahoo Finance.

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