Morningstar Sees Appetite for ESG Despite Poor Results

While ESG investing becomes increasingly politicized, pushing the investment strategy well beyond traditional wealth management boundaries, there are signs that some of the largest institutional investors still see value in focusing on environmental, social and governance when it comes to portfolio construction. 

A new report from Morningstar Indexes and Morningstar Sustainalytics shows that 67% of asset owners believe ESG has become more material to investment policy over the past five years, with the environment and issues around net-zero emissions targets cited as key ESG drivers. 

The Morningstar Voice of the Asset Owner report is based on a survey of 500 asset owners, including pension funds, insurance general accounts and large family offices, across 11 countries with combined assets of nearly $11 trillion. 

Still Committed to ESG

Thomas Kuh, head of ESG strategy at Morningstar Indexes and one of the report’s authors, said the findings “confirm that institutional investors remain highly committed to integrating ESG factors into their global investments, but challenges related to lack of regulatory clarity and the need for better data and resources continue to persist.” 

Survey respondents ranked market data, the market environment and regulation as the biggest implementation challenges to ESG investing. Specifically, the report details that ESG market data is hindered by lack of standardization, reliability and timeliness. 

A third of respondents cited ESG regulation as an implementation challenge, representing an increase of 10 percentage points from last year’s report. But the leading implementation issue for the second consecutive year was poor investment performance.

Challenging 2022 for ESG 

“Sustainable investment strategies had a challenging year in 2022 amid strong performance of carbon-intensive energy and utilities sectors and the downturn of more ESG-friendly technology stocks,” the report states. 

Kuh characterizes the underperformance for ESG in 2022 as an anomaly, adding that Morningstar’s research shows that while sustainable funds underperformed in 2022, they outperformed on the three-, five- and 10-year periods.  

“Last year was an unbelievably rocky year for the market,” he said. "Morningstar’s view is that investors should be invested for the long term.” 

While it is true that ESG strategies, which tend to own fewer energy sector stocks and more technology sector stocks, will ebb and flow in stride with the tech sector, the flow of assets out of ESG ETFs this year suggests investors are not convinced. 

The three largest ESG ETFs tracked by etf.com are all suffering net outflows despite positive performance this year. The $12.2 billion iShares ESG Aware MSCI USA ETF (ESGU), is up 14% this year and has seen $9.2 billion in net outflows, the most outflows of any ETF this year. The $6.9 billion iShares ESG Aware MSCI EAFE ETF (ESGD) is up 7.9% and has suffered $54 million in net outflows. The $6.5 billion Vanguard ESG U.S. Stock ETF (ESGV) is up 17.4% this year and has $20 million in net outflows. 

Lack of Regulatory Clarity

Beyond investment performance, the institutional investors expressed a desire for more direction from regulators when it comes to ESG investments. Among those respondents saying “ESG regulations have been a hindrance” 42% see the regulations as confusing or unclear.  

While survey respondents note “marked improvement in the quality of ESG, ratings, indexes and tools over the past five years, nearly half say they would benefit from more accuracy when it comes to ratings. 

When asked which elements of ESG ratings, indexes and data need to be improved most over the next five years, quality and relevance topped the list for the second straight year.  

Despite the list of identified challenges, the respondents generally report plans to increase allocations to ESG strategies. 

Contact Jeff Benjamin at [email protected] and find him on X: @BenjiWriter