Record-breaking year for sustainable funds: Morningstar

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Investors embraced sustainable funds at unprecedented rates in 2021 as the number of available funds skyrocketed in the United States, according to a new report from Morningstar.

“Sustainable Funds U.S. Landscape Report” details an array of metrics that point to the accelerating popularity of sustainable funds. Among the more striking statistics:

• Sustainable funds attracted a record $69.2 billion in net flows in 2021, a 35% increase over the previous record the year before, and
• Assets in sustainable funds landed at a record $357 billion by the end of the year – more than four times the total three years ago, delivering a clear picture of the tidal shift that has occurred in the category.

In addition, the number of sustainable open-end and exchange-traded funds available to U.S. investors increased to 534 during the year, reflecting growth of 36% from 2020. During the course of the year, 121 new sustainable funds launched, compared to just 71 the previous year.

“Between fund launches and repurposed funds, an unprecedented number of new sustainable funds came to market, and these funds offered greater variety than seen before in terms of their approaches to sustainable investing,” the report said.

At the end of the year, 375 of the 534 sustainable funds available to U.S. investors were actively managed offerings, accounting for 70% of these particular funds, but active funds’ market share has been declining as investors increasingly turn to passive funds. “Three years ago, active funds claimed 81% of sustainable assets; by the end of 2021, that shrank to 60%,” according to the report.

The lists of the 10 largest actively managed sustainable funds and the 10 largest passive sustainable funds remained largely unchanged from 2020. Parnassus Core Equity tops the field of actively managed sustainable funds, while iShares ESG Aware MSCI USA ETF is the largest of the passive funds. By asset class, 138 sustainable funds fall into the U.S. Large-Cap category.

In terms of performance, the report indicates that sustainable funds had a successful year in a challenging climate. Sustainable equity funds, which account for 374 sustainable funds in the U.S., tend to favor growth stocks and avoid traditional energy stocks. That approach helped in 2020, but held them back during the first quarter of 2021. Still, “most recovered to deliver handsome calendar-year results,” according to the report.

“Sustainable funds encountered greater performance challenges in 2021, compared with 2020, but they continued to deliver strong returns versus category peers and their respective Morningstar category indexes,” the report said.

In addition to investment returns, Morningstar evaluated how well sustainable funds emphasize sustainability in their portfolios. The report notes that these funds use a variety of sustainable investing approaches, leading to different portfolio profiles. As a result, some “assess performance in areas like business ethics, treatment of workers, carbon emissions, and pollution,” while others “narrow their approach to focus on particular themes, like gender diversity in companies or climate change mitigation strategies.”

In its evaluation, Morningstar examined how well sustainable funds are limiting their portfolios’ exposure to environmental, social and governance (ESG) risk compared with peers, using the Morningstar Sustainability Rating. Morningstar found an increasing broadening of the portfolio characteristics of sustainable funds and the approaches they take to sustainable investing. For instance, climate-focused strategies range from seeking to reduce or remove exposure to carbon risk to investing in companies that are developing solutions to climate change.

Overall, Morningstar found that sustainable funds have much lower levels of ESG risks in their portfolios than their peers. Sixty-nine percent of sustainable funds received the highest or second-highest rating in the evaluation, compared with one-third of funds overall. Meanwhile, 13% of sustainable funds received the lowest or second-lowest rating versus one-third of funds overall.

The Morningstar report notes that an “increasingly important dimension of sustainability is stewardship: how a fund engages with the companies it owns, votes proxies and seeks to provide measurable impact beyond financial return.” In 2021, 72 ESG-related shareholder resolutions appeared on proxy ballots, and 36 passed with majority support – up from the 20 that passed in 2020. Sustainable funds supported 85% of the key ESG resolutions on which they voted, according to the report.

That level of activity appears to be a sign of things to come.

“As investors put more money into sustainable funds, the collective influence of these strategies via their proxy voting also grows,” Morningstar said.

Looking ahead, the report pointed to regulatory developments that could impact sustainable funds in 2022 and beyond. These included a Department of Labor proposal to make it easier for employers to offer sustainable funds in their workplace retirement plans, a proposal that could increase proxy-voting activities on behalf of investors, and SEC efforts to mandate disclosures related to climate risk and human-capital management.