The Scalable Solution for ESG Investing
The "heat" of ESG funds is getting colder—by the third quarter of 2023, net inflows into global sustainable (ESG) funds had fallen below $20 billion, a level not seen since 2019. Europe, which has long been the largest market for sustainable funds, received a net inflow of $15.3 billion, which is far less than in previous years. Asia (excluding Japan) recorded net inflows of approximately $200 million, while ESG funds in the U.S. and Canada continued their downward trend, recording net outflows.
However, from these figures, a bright spot emerges: in Europe and Asia, where sustainable funds still managed to attract new capital, the inflows went to passive funds, namely index funds (ETFs).
The ESG fund market has always been dominated by active funds. In the past, some analysts believed that, in addition to insufficient data disclosure and a lack of third-party verification of much of the ESG information, passive funds had their specific limitations. For instance, research and stock selection are controlled by index providers rather than fund managers, making it difficult for investors to exercise effective oversight. Additionally, the need to track a benchmark index limits the strategic scope of ESG indices.
However, passive funds have the advantage of lower management fees, which reduces the cost for investors and facilitates the rapid scaling up of sustainable investment products. Currently, this advantage appears to be reflected in investor choices. Although passive funds still account for only 28% of the ESG fund market in Europe, their size has nearly tripled over the past three years.
We believe this trend may be due in part to the significant concerns about greenwashing faced by active ESG funds. The limitations of passive ESG funds mentioned above boil down to their "unreliability," meaning that investors cannot be certain whether these funds and the indices they track genuinely allocate capital to areas that support climate action and social equity.
However, the recent wave of greenwashing allegations against financial institutions has also cast doubt on whether active ESG funds are more trustworthy. According to news reports, the Center for Economic and Policy Research (CEPR) released a report pointing out that fund managers responsible for sustainable funds in the U.S. temporarily increased their holdings in companies with ESG attributes before quarterly disclosure deadlines to boost their ESG ratings, only to revert to higher-yield investments after the disclosure period.
Furthermore, with the tightening of regulations, many asset management institutions have chosen to remove ESG/sustainability keywords from fund names to avoid being penalized, which has added to investor concerns.
Although ESG index funds have begun to show some relative advantages, doubts about this type of product have never truly ceased.
In April 2023, the research organization Common Wealth released a report analyzing ESG bond funds managed by ten globally renowned institutions (including both active and index funds), revealing that these funds collectively invested over $1 billion in bonds issued by fossil fuel companies.
Moreover, a news report from March 2023 pointed out that the UK's Financial Conduct Authority (FCA) stated that the quality of ESG-related information disclosed by index providers was generally poor, warning that this could prevent ESG indices from fulfilling their intended role of guiding ESG investments, thereby exacerbating greenwashing behavior. Both active and passive funds need more rigorous methodologies and stronger data support to respond to greenwashing concerns effectively.