Investors have withdrawn a staggering $13 billion from U.S. sustainable funds in 2023, citing lackluster returns and the growing skepticism towards environmental, social, and governance (ESG) investing.

Last year witnessed the highest outflows in over a decade, as reported by Morningstar.

A significant portion of these outflows can be attributed to the sharp decline in one passive iShares ESG fund, according to Morningstar.

Underperformance has been a major contributing factor. In 2023, sustainable equity funds generally trailed their conventional counterparts, although the gap wasn't as wide as in 2022.

Alyssa Stankiewicz, associate director for sustainability research at Morningstar, stated that some investors had an erroneous belief that "ESG was a silver bullet to outperformance." She added that this misconception caught people off guard in 2022 and 2023.

In 2023, the median sustainable large-blend equity fund posted a gain of 20.8%, compared to 23.9% for the overall category (which includes both sustainable and conventional funds), and 26.9% for the Morningstar U.S. Large-Mid Cap Index.

Sustainable funds that held positions in last year's top performers, such as software giant Microsoft and graphics processor manufacturer Nvidia, experienced a boost in their performance.

However, funds with significant investments in clean-energy stocks suffered due to the downturn in the sector. Higher interest rates resulted in increased borrowing costs for renewable energy companies and limited their capacity for expansion.

For instance, the Invesco WilderHill Clean Energy exchange-traded fund, which is considered a benchmark for green power, declined by 20% in comparison to the S&P 500's return of 26% (including dividends).

The disappointing performance of sustainable funds coincided with a growing backlash against ESG strategies.

Sustainable Investing in the Political Spotlight

Sustainable investing has been a topic of intense political debate, leading to some investors feeling skeptical or hesitant. The latest development in this ongoing battle comes from Republican lawmakers in New Hampshire, who have introduced a bill that would criminalize the use of environmental, social, and governance (ESG) criteria in state investment funds.

One specific fund that experienced significant outflows last year is BlackRock's iShares ESG Aware USA ETF, which accounted for a substantial portion of the overall decline in sustainable funds. This $13.5 billion fund tracks the MSCI USA Extended ESG Focus Index and applies screens to exclude companies involved in activities such as tobacco production, controversial weapons, and thermal coal production.

Investors withdrew over $9 billion from this ETF throughout the year. However, Morningstar highlighted that these outflows were partly influenced by the replacement of the iShares ESG Aware MSCI USA ETF with a different ETF, the iShares USA Quality Factor, in BlackRock's flagship target-allocation ETF model portfolios. BlackRock has confirmed this trade.

As the world's largest asset manager, overseeing $10 trillion in assets, BlackRock has faced significant backlash from Republican-led states concerning its ESG investing practices.

Despite these outflows, assets in sustainable funds reached $323 billion by the end of 2023. Although this represents a nearly 12% decline from the previous record at the end of 2021, it still reflects an 18% increase from the low point in the third quarter of 2022, according to Morningstar.

Interestingly, for the second consecutive quarter, more sustainable funds closed than launched. In the fourth quarter, only seven new sustainable funds were introduced, while 16 existing funds closed.

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