Will Sustainable Funds Maintain Their Popularity in 2024?

In Canada, both categories of equity and fixed income sustainable funds outperformed their traditional peers in 2023 with median returns of 12.55% and 6.99% respectively, compared to 12.16% and 6.52%, reports Danielle LeClair, director of manager research at Morningstar Canada. However, median sustainable Canadian and U.S. equity funds slightly underperformed their relative Morningstar Canada Index and Morningstar US market index.

Sustainable funds also outperformed in the US, according to a recent Morgan Stanley report: median returns of 16.7% and 10% for equity and fixed-income sustainable funds respectively versus 14.4% and 6.4% for their traditional counterparts.

Sustainability Outperformed Globally

The outperformance is not limited to Canada and the US, but holds worldwide, according to Morgan Stanley. Global median returns for sustainable funds, equity and fixed income combined, inched up by 12.3% globally against 11.5% for their traditional peers; in Europe, the numbers are 14.1% versus 12.1%.

Europe occupies an unexpectedly large footprint in the “sustainability” universe. Europe-domiciled funds account for 87% of global sustainable assets under management, with only 10% residing in North America, notes Morgan Stanley, although only 35% of sustainable assets focus on Europe for their investments. 

The year 2023 records the second-highest performance point of sustainable funds. The previous high watermark was in the first half of 2020 when combined equity and fixed-income sustainable funds raked in returns 321 basis points above traditional funds, registering a 20.5% return versus 17.3%. In the first half of 2023, the spread in favour of “sustainables” was 314 basis points or 6.7% versus 3.6%. Over the five-year period stretching from December 2018 to December 2023, a $100 investment in the sustainable universe of funds would have returned $135 versus $125 in the traditional one.

In the large-cap segment, where more than 75% of sustainable funds focus, returns dominate in the three major categories of value (13.8% vs 10.2% for traditional funds), “blend” (15.6% vs 11.5%) and growth (17% vs 12.3%). It is only in the small-cap segment that traditional funds significantly outperform sustainable ones: 11.7% versus 6.2%.

Sustainability Didn’t Sustain as Well in Canada

In Canada, performance over three- and five-year periods is not as brilliant. “Over both time periods,” notes LeClair, “sustainable funds underperformed their peers, with over half ranking in the bottom half of their respective peer groups.” However, in 2023, sustainable funds, in the equity as well as in the fixed income categories, came out ahead, but only by a bit. “In terms of total returns,” adds LeClair, “sustainable funds beat their conventional Morningstar peers slightly in 2023, with 55% of sustainable funds landing in the top half of their respective Morningstar categories.”

The top performers reside in fixed income for 2023, “with 39% of sustainable fixed-income funds ranking in the top quartile relative to peers,” LeClair notes. Among global fixed-income funds (the largest Canadian sustainable bond fund group), the oldest share class of the median sustainable fund gained 7.1%, beating the entire category’s 5.5% and the Morningstar Global Core Bond Index’s 2.4%. (“Oldest share class” refers to the first available share class of a fund.)

Technology Stands Out As ESG Performance Driver

Much of the outperformance of 2023 in Canada hinges on technology, observes LeClair, where sustainable values are easily championed in comparison to the energy sector. “Entering 2023, two-thirds of the universe held relative over-weightings to technology, which trounced all other sectors with its 65% gain,” she reports. “Additionally, over 80% of funds had relative under-weightings to energy, where middling results weighed on the index, given it is the second-largest sector. Large consumer sector over-weightings hurt.”

However, the strongest over-weights are found in communication services, at 95%, and consumer defensive, at about 84%. Unexpectedly, over-weighting to industrials, where sustainable values have a mixed showing, is quite high at 58%, not very far from technology (63%) and financial services (62%). After technology, with its 65% returns, consumer cyclical, financial services and industrials contributed the strongest returns with 17%, 14% and 12% respectively.

In other regions around the world, Morgan Stanley believes that sector exposures “accounted for around half of the relative performance of sustainable funds”. Funds investing in the Americas, are overweight technology, “with this sector making up 29% of AUM on average versus 23% for traditional funds”, suggests the report. On a global level, industrials are the sector where sustainable funds are the most overweight (18% vs. 11%), and they are most underweight in energy and financials. In Europe, health care shows the largest overweight (14% vs. 11%), and energy is the most significant underweight (2.2% vs. 4.4%).

Not Clear Outperformance Will Continue in 2024

Assets in Canadian sustainable funds hit an all-time high in the first quarter of 2024, reaching $50.5 billion. However, the amount of money flowing into funds has been steadily declining since the heydays of 2021 when net inflows were close to $2.5 billion every quarter. Since the second quarter of 2023, flows have trickled down to about $300 million per quarter, rebounding to $200 M in Q1 2024 after a slight contraction in Q4 2023.

The strong performance of sustainable funds in 2023 has not extended in 2024 to this day, LeClair finding that they have “underwhelmed in the first quarter of 2024”. “In my opinion, she says, the performance behaviour of ESG funds is still being established. I would still suggest performance is fund specific and reliant on factors outside of their ESG approach as well as the ESG approach applied.”

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