2020 was a watershed year for ESG funds. Investment strategies that take environmental, social and corporate governance factors into account enjoyed record inflows; over the last year, a third of inflows into global funds was invested using ESG strategies, rising to more than half in June and July.

As of September, global inflows into sustainable funds are up again, reaching $80.5bn, and assets in sustainable funds are at an all-time high. Numbers suggest that this was money well invested: 40 percent of ESG and sustainable funds made top-quartile returns in the first half of this year, with the average ESG outperforming its traditional peer, according to Trustnet. The idea that sustainable investment sacrifices returns for morals has been well and truly put to rest.

The COVID-19 pandemic is partially responsible for the spike in inflow, as investors seek sustainable investments that can withstand an unpredictable market. Hortense Bioy, Director of Sustainability Research at Morningstar, told World Finance: “The disruption caused by the pandemic has highlighted the importance of building sustainable and resilient business models based on multi-stakeholder considerations.” The global health crisis has had an impact on all categories of the ESG model: beyond health and safety, the pandemic has resulted in increased interest in employee benefits and “renewed focus on management compensation”, says Bioy, as well as intensifying already increasing concern over the climate crisis. Similarly, the success of ESG funds this year has been widely attributed to favourable sector exposure driven by the pandemic.

Sustainable investment tends to avoid oil and gas, the value of which plummeted earlier this year; despite oil prices stabilising after dipping to sub-zero in the US for the first time in history, energy stocks continue to underperform. On the other end of the market, tech stock is heavily prevalent in ESG strategies: in October, Apple, Amazon, Facebook and Google-owning Alphabet were up 18 percent year on year.

There is a sense that the success of ESG is attributable to special circumstances. But as of July, the ubiquity of tech stock – eight of the 10 best performing large-cap funds using ESG metrics have either Apple, Amazon or Microsoft as their biggest holding – has led to lasting success: almost 60 percent of sustainable funds delivered higher returns than their conventional counterparts over the past decade.

Research conducted by the World Resources Institute suggests that differences in sector exposure accounts for just 0.77 percentage points of current ESG over-performance; a significant 0.65 percentage points were gained by picking better-performing stock within each sector, suggesting that ESG is an effective measure of financially successful investment.

The numbers are impressive. But the vogue for ESG is plagued by accusations of greenwashing, calling the strength of ESG’s claim to sustainability into question. While ESG fund integration considers a company’s ESG profile, financial performance remains the top priority when purchasing stock. This is where ESG differentiates from socially responsible investing (SRI) and impact investing, which respectively screen investments according to specific ethical guidelines and prioritise quantifiable social impact.

What’s more, ESG valuation is conducted independently or using an agency score, the latter of which was recently deemed unable to “facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise” by the chair of the SEC. Varying definitions and methodologies mean one company can attract scores across the spectrum, making it increasingly difficult for investors to identify truly sustainable companies. ESG continues to be dominated by the European market, and, according to PwC, European sustainable investment products could increase threefold by 2025, outnumbering traditional funds.

Proposed regulations developed by the EU, set to commence over the coming years, outline a number of environmental objectives driven by the EU’s pledge to become climate neutral by 2050, including pollution prevention and the transition to a circular economy. Regulating non-financial sustainability-related disclosures aims to enhance the comparability of financial products; the catch-all nature of the disclosure guidelines means they will cover the vast majority of funds that currently claim to use ESG strategies, and the appeal of retaining its marketing advantage will outweigh the administrative burden.

Philipp Woelk, EU policy officer at responsible investment charity ShareAction, told World Finance that the regulation could have more influence on which funds ESG inflows will be directed towards rather than impact its booming growth. “Ideally, the regulation will shift funds to the ‘better’ ESG funds and ultimately push the laggards, who, until now, have benefited from the ESG or sustainable label, to do more ESG integration.” The initiative does not strictly aim to make ESG an exclusive status but rather to direct capital towards more sustainable growth and make broader, non-financial considerations a vital element of mainstream sustainable investing

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