Is 2024 past peak ESG?

Until recently, new ESG funds–both active and passive–seemingly flooded the U.S. (and global) markets to match investor demand. After years of ESG (and its alter-ego anti-ESG) being a part of the cultural zeitgeist, the trend has reversed. In the first half of 2024, the U.S. ESG market experienced net outflows of over $13 billion, on the heels of a $9 billion outflow in 2023.

We are undertaking an event study of the SEC’s Names Rule Amendment to observe the relationship, if any, between the SEC regulations and the cooling ESG market. While the data collection is incomplete because the rule won’t be fully effective until July 2026, we share our preliminary data below and the questions we hope to answer.

First, we must address the empirical elephant in the room: what is an ESG fund? In prior work, we wrestled with the definitional questions of ESG in practice beyond the three words: environmental, social, and governance. The Names Rule Amendment defines ESG by targeting fund names with “terms indicating that the fund’s investment decisions incorporate one or more ESG factors.” Morningstar, on the other hand, focuses on keywords like sustainability, impact, environmental, or social. How you define ESG influences the count, as shown in Figure 1.

Figure 1:  Count of ESG Funds 2011-2023

Morningstar, for example, counted nearly 2500 fewer sustainable funds globally in 2023 than in the prior year, with 2024 on track for an even steeper plunge. For this post (and our larger empirical project), we use the conservative count of fund names, which corresponds to the regulatory focus of the SEC’s new rules. Our preliminary data mirrors findings by Morningstar and ICI: the field of ESG products is shrinking. No matter which count you use, at the close of 2023, the ESG fund landscape had contracted to the number of ESG funds available in 2016.

Three market-shaping events may be contributing to a tightening ESG market.

The SEC and the drop in ESG funds

The SEC’s recent regulatory actions regarding fund names and ESG disclosures may have spurred sponsors of funds formerly styled as “ESG” to shift their names or investment practices, in order to comply with the new rules or to avoid their application. Amendments to the “Names Rule” in 2023 added ESG to the list of terms that, when used in a fund name, require the fund “to adopt a policy to invest at least 80% of their assets in accordance with the investment focus that the fund’s name suggests.”

The SEC Names Rule amendments sought to narrow the investing field by restricting ESG-advertised funds to those that deliver on the ESG promise. The SEC has been concerned about greenwashing funds in particular, because “unlike many other non-ESG investment strategies, some ESG-related strategies are not well-established or commonly understood to the investing public.”  Adding ESG and sustainability-related terms to the SEC’s list of magic words in the Names Rules also sets a minimum amount of ESG (80% of assets invested in the strategy) to qualify.

These amendments became effective in December 2023, but fund groups were given a 24-30 month phase-in period to comply, with the timeline depending upon firm size.

Funds are in the middle of the regulatory window– the time between when rule-making initiatives are announced and when final rules are completely effective– but research suggests that compliance takes place over a rolling period, rather than as an on/off switch. In other words, if the Names Rule weeds out greenwashers, early signs should be evident now, one of which may be the declining number of ESG funds. Early research suggests that funds marketed with ESG labels and strategies are engaged in some ESG investment, but questions remain. Data from our event study on exits from the pool of ESG-named funds may shed additional light on this important debate. With only the pure number of exits, though, this data might tell several different stories.

A story about ESG funds closing because the SEC regulations are a success goes like this. The number of ESG funds is dropping as formerly greenwashing “ESG” funds close or change their names to avoid violating the new regulation. These funds were using the ESG label as a promotional tool, despite pursuing a more conventional investment strategy, and now have to adjust their names to reflect that reality.

Sponsors might also be removing ESG from fund names– and making other changes to fund strategies and practices– to avoid potential new disclosure obligations separate from the Names Rule Amendment. In a 2022 proposal, the SEC floated new disclosure requirements for funds that consider ESG factors in their investment decisions. The proposal would create three categories of ESG funds and impose tiered disclosure obligations upon them. “Integration funds,” those considering ESG factors along with other factors in selecting investments, would disclose how they incorporate ESG factors into their investment analysis. “ESG- focused funds,” in which ESG is the “significant or main consideration” in selecting investments or engagement policies, would have more detailed disclosure requirements, including structured tabular disclosure for investors to compare across funds. “Impact funds,” which pursue a particular ESG goal, would have to satisfy the most detailed disclosure requirements, including describing the metrics they employ in charting progress toward their ESG goals.

The ESG disclosure rule has been the subject of considerable comment and has not yet been adopted by the SEC. Although fund sponsors need not be concerned with immediate compliance under this proposal, the SEC’s release highlights the possibility of regulation in this area. The proposed disclosure regulations may be propelling “ESG” funds without real ESG strategies to back them up to abandon this marketing ploy. Sponsors may also be shifting funds away from an ESG focus to avoid future regulatory costs.

The politicization of ESG and the drop in ESG funds

While the SEC was busy bringing ESG investing into its regulatory fold and adopting corporate climate disclosure requirements, a bracing anti-ESG, woke capitalism backlash was growing. State governors, attorneys general, and legislatures acted to restrict ESG as an investment strategy and a corporate priority. 

In 2023 alone, lawmakers in 47 states proposed (and many passed) anti-ESG legislation, like Indiana, which prohibits state pension money from investing in ESG assets, and Alabama, which prohibits government contracts with companies that boycott certain industries (e.g., fossil fuels) or companies based on ESG criteria. Florida Governor Ron DeSantis led a coalition of 19 Governors declaring that the “proliferation of ESG throughout America is a direct threat to the American economy” and decrying the “woke mob” that “inject[s] political ideology into investment decisions, corporate governance, and the everyday economy.” Twenty-one state Attorneys General jointly warned asset managers that commitments to the ESG goal of achieving net zero called into question their fiduciary duty to clients and compliance with antitrust laws.

Consumers jumped on the anti-ESG bandwagon making their own headlines in 2023 for actions like boycotting Bud Light for paying a transgender influencer to endorse the beer and criticizing Chik-fil-A for its DEI policy. More than half of companies responding to a Conference Board survey that same year reported experiencing ESG backlash, with financial and insurance services feeling the most targeted. As a result of this political tug-of-war, many companies have reversed course, like JP Morgan, State Street Global Advisors, and PIMCO, which withdrew from Climate Action 100. Other companies have simply gone quiet (a practice called greenhushing), like Anheuser-Busch InBev, Bud Light’s parent, which has stopped advertising its net-zero by 2040 and 100 percent recycled packaging by 2025 goals.

With a political bullseye and fickle consumer support for ESG investments and corporate policies, maybe ESG has simply become too costly a strategy to pursue. Shifting their portfolio of offerings away from identifiable ESG practices may be an expedient way for fund sponsors to avoid political hassles and bad publicity, not a reaction to new or proposed SEC regulations. After all, real dollars, not just a PR campaign, are at stake. Earlier this summer the Indiana Treasurer placed BlackRock on a state watchlist for making “illegal ESG commitments.” Moves like this could jeopardize BlackRock’s management of trillions in public retirement system assets.

Weakening investment demand and the drop in ESG funds

Of course, the market moves much more quickly than regulation, legislation, and even political theater. During the time in which the SEC and state elected officials shifted their ESG activities into high gear, American investors seemed to be hitting the brakes on ESG funds. After at least a decade of positive inflows, in the fourth quarter of 2023, “U.S. sustainable funds suffered their first calendar year of outflows since Morningstar began keeping track.” Although investment markets have been soft overall, the downturn for ESG funds is more acute than for their conventional counterparts. This decrease in ESG investment demand could also explain the falling number of ESG funds.

Fund sponsors matching offerings to investor demand may simply be following the crowd away from ESG. When asked by Bloomberg for the reasons behind its closure of three ESG ETFs, Investment giant State Street pointed to “investor feedback and market demand.” Columbia Threadneedle similarly credited “limited investor interest” as part of its impetus for closing a social bond fund.

While fund sponsors will understandably be reticent to explain their reasons for fund closure decisions, responding to softening consumer demand appears to be one explanation at least some firms are willing to admit. These explanations can be self-serving, but they may also be true. Formerly ESG-named funds might not have been greenwashers, but genuine ESG funds, and their sponsors might well have been willing to shoulder the necessary compliance burden to continue offering them if ESG investment demand remained high. But not in today’s market environment, where investor interest in ESG funds appears to be waning and money managers are “cleaning up the shelves” in part due to limited investor interest.

The drop in ESG funds is business as usual

Standard explanations for fund closure too might be a significant part of the real story behind the drop in ESG funds. Sponsors might be closing ESG funds following poor performance, to pursue economies of scale through consolidation, or simply as a result of fund complex reorganizations. For example, iShares MSCI Germany Small-Cap ETF closed after poor performance in 2022-2023. The Northern Lights Fund Trust: Zeo Sustainable Credit Fund consolidated with acquirer Osterweis Capital Management LLC and now trades as Osterweiss Sustainable Credit Fund. And TIAA-CREF Social Choice Equity Fund recently changed its name to Nuveen Large Cap Responsible Equity Fund after a reorganization. These routine closures obscure what we can learn about the impact of SEC regulation from the pure number of ESG funds exiting the category.

Building an event study

The field of ESG-named funds before and after the SEC’s regulatory shock operates as a natural event study, and after the event in question, the number of ESG funds went down. It is hard to disambiguate the different causal threads and consequences. Comparing the number of funds after the final effective date in July 2026 is one way to peer into the dynamics of a shrinking ESG investment market. Extending our observation window past the final compliance date in 2026 will expand our data. An extended timeline is valuable to include as many fund closures and changes potentially prompted by the amendments as possible and to limit the impact of short-term market developments on our analysis.

The number of exits alone will not answer our questions, nor can we expect fund sponsors to candidly reveal their full explanations. Unpacking additional data, like changes to fund investment strategies and shifts in portfolio holdings, will help sharpen our analysis of the drop.

The SEC’s adoption, abandonment, or continued silence on the proposed ESG fund disclosure rules will also shape our study. Should the SEC adopt the disclosure rules, we will have a clearer definition of ESG funds for our counting exercise. Unless and until the fate of the disclosure proposal becomes clear, we will use the conservative count generated by a textual analysis of fund names alone. Further, if the proposed ESG disclosure rules become final, we will consider the increased regulatory pressure it will exert to shift funds out of the ESG category. If the proposal falls away, perhaps due to a change in administration and agency leadership, its current latent influence will wane.

Is 2024 past peak ESG? Only time – and more research – will tell.