Skip to main content

The flow of investor money into sustainable funds in Canada has slowed to a trickle, as the ESG space globally faces intense scrutiny from investors and regulators.

One of the hottest trends of the pandemic-era bull market, environmental, social and governance-themed investments have taken a big hit this year.

With the appetite for green investments waning in the United States, many Canadian investors appear to be cooling on the theme as well.

Canadian exchange-traded funds with an ESG tilt saw net inflows of just $3-million in August, after taking in an average of close to $400-million a month through the first half of the year, according to data from National Bank of Canada.

It’s the latest sign that the credibility and performance issues swirling around the industry could be catching up with the Canadian ESG space.

“The prevailing global backdrop will resonate through negatively in the near-term,” Baltej Sidhu, an ESG analyst at National Bank, wrote in a recent report. “We would be remiss in not highlighting to the investment community to exercise caution.”

Jeffrey Jones: As ESG strategies change, impact investing is on the rise

How to pick the right ESG-focused ETFs

It has been an abrupt heel turn for the virtuous ESG segment.

In the two years prior to 2022, demand for investments wrapped in ESG principles soared as the global climate crisis took on new urgency. It certainly didn’t hurt that investors could juice their returns at the same time as committing money to good causes.

Over the past five years, large-cap ESG funds in the U.S. posted an average return of 14 per cent annually, compared with an 11-per-cent average return of their non-ESG counterparts, according to Morningstar.

Fund companies clambered to cater to the market’s ravenous appetite. In Canada, 21 per cent of all new ETF launches last year incorporated some form of ESG screening, according to National Bank. (By contrast, ESG’s share of the overall Canadian ETF market, as measured by assets under management, is only about 3 per cent.)

Much of the stellar track record of ESG funds in recent years, however, was the result of heavy exposure to the tech sector, which was in the midst of a multiyear bull run. This year, that weighting has turned against ESG, as Big Tech stocks have collapsed.

The rise of energy stocks, which many ESG funds exclude, has been another drag, and is a big reason that just 3 per cent of ESG equity funds listed in the U.S. have positive returns this year, according to Bloomberg data.

But any notion that ESG funds should renounce the oil and gas sector is misguided, said Lisa Meger, a portfolio manager and ESG analyst at Leith Wheeler Investment Counsel.

“There’s this idea in ESG that there are good and bad industries, but I would argue it’s more about finding good and bad companies. There are good companies in the energy sector, and we still need their resources,” Ms. Meger said.

Performance issues aside, the ESG space is also fighting a battle on reputational lines. Investor confidence has been shaken by allegations of widespread greenwashing, whereby funds are inappropriately classified as sustainable. Earlier this year, Morningstar stripped the ESG tag from more than 1,200 funds listed in Britain that were failing to deliver on ESG goals.

“There’s been so much interest in this space and it can be easy to just slap on an ESG label,” Ms. Meger said.

And yet, in the first half of this year, before the major slowdown in August, the pace of money going into Canadian ESG funds appears to have barely slowed. But that, too, may be a bit of an illusion.

ESG flows have been dominated by institutional money in Canada, punctuated by block orders in excess of $100-million. Large spikes like that can come from asset managers launching new ESG funds, and simply funnelling internal money into the new products, said Linda Ma, an ETF analyst at National Bank.

Institutional demand seems to be carrying the space – the month of August aside – while retail interest appears limited.

But some growing pains in terms of classification, in addition to a run of bad luck with sector tilts, don’t mean ESG investing has been exposed as inherently lousy, said Dan Hallett, vice-president of research and principal at Highview Financial Group.

There is a sound common-sense argument to making ESG principles part of the investment process, he said. “A business that is well organized enough that it has really strong governance, that it’s treating its people well, and that it’s sensitive to the community and environment around it, it’s probably got it together in a lot of other ways.”

Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.