The Tell: Investors may be willing to sacrifice returns for ESG — but here’s where they haven’t had to, says Deutsche Bank

United States

Investors are flocking to sustainable funds in the U.S. as performance over the past three years shows they haven’t had to sacrifice returns when buying assets in line with their environmental, social and governance criteria, according to Deutsche Bank research published Thursday. 

“Organic growth in sustainable products is accelerating, especially in the U.S.,” the Deutsche Bank analysts said. “We see net flows remaining high given rising retail interest in ESG, along with continued strong performance relative to non-ESG funds.”

For individual investors trying to decide whether to go with a passive investment fund in ESG, or one that is actively managed, Deutsche Bank’s research suggests passive may be the way to go — at least for now. 

“Active retail products have yet to demonstrate a significant and consistent performance advantage over passive products across most categories we analyze,” the analysts said. “Passive funds will likely continue to gain share vs. actively-managed products within sustainable investing in the near-to intermediate term.”

Thematic investing, which has helped propel growth in passive ETFs, lends itself well to ESG, according to Deutsche Bank. Low carbon, solar, electrical vehicles, and social diversity are among the many themes attracting investors, the analysts said. 

“Theoretically, ESG themes could number in the hundreds (or more) depending upon how narrowly defined, and to what extent ETF providers see demand,” the analysts wrote. 

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BlackRock’s iShares, Invesco and Vanguard Group are the top three providers of sustainable ETFs in the U.S. based on assets under management at the end of April, the report shows. 

ESG assets managed by mutual funds and ETFs have risen to almost $ 4 trillion globally, nearly doubling in about 2½ years, the analysts said, citing Morningstar data. Investors may choose “exclusionary” funds that omit certain investments from their portfolios because they fail to meet their ESG criteria, or “sustainable” strategies that seek to invest in companies with stronger ESG merits.

Funds labeled “sustainable” have grown faster, almost doubling assets in the U.S. over the past year, according to Deutsche Bank. The pace of “sustainable” fund growth is slower outside the U.S., with assets up about 75% from a year ago, the report shows.

But the U.S. is playing catch up on ESG. “We consider Europe to be broadly in a leadership role globally when it comes to ESG investing, not to mention adoption of ESG principles and regulation,” the analysts said. 

To be sure, many growth-oriented, technology-heavy ESG funds have fallen this year amid a rotation into value stocks. MarketWatch last week reported that Invesco Solar ETF TAN, -0.26% and iShares Global Clean Energy ICLN, +0.48% were among those with sharp losses in 2021.

See: ESG funds are ‘going to suffer’ as tech stocks lag and value beats growth

But investors in actively managed sustainable equity mutual funds in the U.S. haven’t had to do much sacrificing in recent years compared with non-ESG funds, according to Deutsche research.

The sustainable funds returned an average 18.2% on an annualized, asset-weighted basis over the three years through April, beating the 15.5% gains of non-ESG funds over the same period, the report shows. “The return profile is especially remarkable given that many individuals would be willing to sacrifice some return in exchange for the satisfaction of helping to make a positive ESG impact,” the analysts said.

Looking just at 2020 results, non-ESG funds only narrowly outperformed, with their average 22.9% returns beating the 22.5% gains produced by sustainable funds. But from the first quarter of 2019 to the first quarter of this year, actively managed sustainable ESG funds in the U.S. had an average gain of 6.5%, exceeding the 5.8% return by the S&P 500 SPX, +0.08%, according to the report.

While there is “not much evidence” to favor active over passive strategies within sustainable investing, the analysts said they did find some examples of recent outperformance, including U.S. large-cap value. They suggested investors weigh long track records when selecting active managers.

Among the largest managers of sustainable active equity funds in the U.S., Brown Advisory, Eventide, Putnam and Parnassus have posted some of the strongest performance over the past decade, according to the report. The top 10 U.S. managers in the group posted 14.4% total average-weighted returns in the past 10 years, the report shows.

Outside the U.S., the biggest managers of sustainable active equity funds have amassed more assets, but “absolute returns have been considerably lower overall, even below the average for the entire European style box universe,” the analysts found. Average 10-year total returns for the biggest managers outside the U.S. were 5.2%, the report shows.

“This is also evidence of European’s willingness to sacrifice returns for the sake of sustainable investing,” the analysts said.