ESG Funds Fail a Big Test

New research shows that mutual funds and ETFs with an environmental, social and governance (ESG) mandate failed to live up to their promises. Those funds, for example, had worse track records for compliance with labor and environmental laws and were less likely to voluntarily disclose emissions data than non-ESG investments.

For the fifth calendar year in a row, sustainable funds set an annual record for net flows: Flows reached $51.1 billion, with $20.5 billion of that coming in the fourth quarter.

The asset management industry has responded to the dramatic increase in demand for ESG investing in recent years by launching a host of “socially responsible” funds that at least nominally account for issues considered important to a business’s overall sustainability: the environment (e.g., carbon emissions), social issues (e.g., employee treatment) and governance (e.g., executive compensation). Morningstar reported that by the end of 2020, the group of sustainable open-end funds and exchange-traded funds available to U.S. investors numbered 392, up 30% from 2019 and a nearly fourfold increase over the past 10 years, with significant growth beginning in 2015.

The SEC takes notice

In March 2021, the Securities and Exchange Commission (SEC) created a new Climate and ESG Task Force to proactively identify misconduct related to ESG issues. The creation of this task force was driven by regulatory concerns that ESG funds are not providing asset owners with products that reflect concern for stakeholder welfare. In April 2021, the SEC stated that it had identified several asset managers that were misleading investors by marketing funds as ESG-friendly but not making investment decisions consistent with such marketing. They also identified some cases where funds did not even have a mechanism to “reasonably track” or screen portfolio firms’ ESG performance. Such cases raise concerns about “greenwashing” – the process of conveying a false impression or providing misleading information about how a company's products are more environmentally sound.