Sustainable funds slightly underperformed traditional funds in 2022. Continued investor interest drove up the proportion of overall assets under management.
Demand for sustainable investment funds remained strong in 2022, according to a new Morgan Stanley Institute for Investing’s Sustainable Reality report analyzing Morningstar data. Despite challenging market conditions that led sustainable funds to slightly underperform traditional funds for the first time since 2018, sustainable funds saw net positive fund flows of $115 billion (around 3% of 2021 year-end assets under management), while traditional funds saw sustained outflows.
By the end of the year, sustainable funds’ AUM totalled nearly $2.8 trillion, an increase in its proportion of overall AUM to 7% from 4% five years ago. Demand was strongest in Europe, which accounted for 89% of sustainable AUM and almost all of 2022’s net inflows to sustainable funds.
Amid an economic environment that included recession fears, inflation and the Russia-Ukraine war, equity investors rotated into value stocks and away from growth stocks, and shorter-dated bonds outperformed in fixed income. Both factors affected sustainable funds considerably, as they tend to focus more on long-term investment plays. As a result, sustainable funds worldwide fell 19%, slightly underperforming traditional funds, which dropped 16%.1
“Despite short-term fluctuations, investors with long-term horizons appear to be holding steady with patient capital in sustainable funds,” says Jessica Alsford, Chief Sustainability Officer and CEO of the Institute for Sustainable Investing at Morgan Stanley.
Sustainable Funds’ Underperformance in Context
In 2022, a rapid rise in interest rates prompted declines in both bonds and equities, a phenomenon not seen in 150 years, according to Morgan Stanley Global Strategy Research.2 The yield curve also inverted, which is typically perceived as an indicator of a looming recession and a signal for investors to position portfolios defensively. Investors favored short-duration bonds over long-duration bonds, which are more sensitive to rising interest rates. As a result, value (stocks trading cheaply) outperformed growth (which prioritizes long-term potential) across equity markets, while high-quality and short-duration fixed income outpaced low-quality and long-duration bonds.
Sustainable funds modestly underperformed traditional funds in 2022
Historical Return—Sustainable vs. Traditional
Sustainable equity funds declined the most in 2022, although the relative underperformance of sustainable funds was greater in fixed income
Median Return by Asset Type
This environment had a number of implications for sustainable investment funds, which tend to be biased toward growth stocks and longer-duration fixed income, given many sustainable investing themes tend to focus on longer-term opportunities tackling issues like climate change, water scarcity and social equality.
For equities, the shift to value stocks hurt sustainable funds’ relative performance, as only 10% of sustainable funds have a value focus, compared to 22% of traditional funds. When weighting for different style exposures, the Institute estimates as much as 110bps of the approximate 150bps of sustainable equity funds’ underperformance was driven by their relatively lower exposure to value. Even so, sustainable growth-oriented funds did outperform traditional growth funds in 2022, particularly in the mid- and large-cap categories.
In fixed income, the broader market response to increasing rates in 2022 favored funds focused on shorter durations. This investor shift impacted sustainable funds, which tend to skew toward long durations. Also notable is that green bonds tend to favor utilities and financials, which both underperformed in 2022, according to Morgan Stanley Fixed Income Research.3
Investor Demand for Sustainable Funds Still Strong
Despite sustainable funds’ underperformance in 2022, investor interest and demand in sustainable fund opportunities remained strong, with sustainable funds as a proportion of total AUM reaching record levels (7%). Notably, while traditional funds saw outflows of $565 billion by year-end, sustainable funds witnessed net positive inflows of $115 billion, signalling strong asset owner demand for sustainable products and strategies, a finding consistent with an Institute survey conducted in 2022.
Regionally, investor demand in Europe far outpaced other geographies, accounting for 89% of sustainable fund AUM and almost all of 2022’s net inflows to sustainable funds. North America was the next largest with about 10%, a slight increase over the previous year. All other regions comprised less than 2% of total sustainable fund AUM. By fund count, Europe is home to more than two-thirds of the world’s sustainable funds, followed by North America (11%) and Asia (7%).
As sustainable solutions such as renewable energy or clean technology become more material for corporate earnings in the short term, sustainable equity funds may skew more toward value than they have in the past. Renewables, for example, are expected to overtake coal as the largest source of global electricity production in early 2025,4 which helps make clean energy a more short-term investment play. Additionally, sustainable funds are becoming more open to considering companies’ rate of change5 toward sustainability goals, which means that they may embrace a broader universe of companies and industries that are working toward improved sustainability, also resulting in a possible shift toward value and shorter duration in fixed income.