Laith Khalaf, Head of Investment Analysis at AJ Bell, comments: “It feels like the ESG party is running out of steam, with investment flows drying up and actually going into reverse. We’ve now had three months of continuous outflows, and in August a record amount was withdrawn from responsible investment funds. Part of the explanation for the ESG slowdown is likely to be the cyclical nature of fund flows. Three years ago ESG was everywhere, fund groups were launching new products and marketing them like crazy, and the saturation point was probably found pretty quickly. All that money flowing in helped ESG funds perform well, attracting more cash from those who follow fund performance tables. After that initial goldrush, ESG funds are now part of the furniture and having to fight hard for inflows like all other sectors.
“The cost-of-living crisis has also shifted the ESG debate somewhat. Energy security and price are now back in the game competing with green priorities. It’s also become increasingly clear how murky and nuanced some environmental questions can be, and a prime example is the decision on whether to licence more drilling in the North Sea rather than import energy from overseas. We’ve also recently seen the UK government rowing back on some of its environmental pledges, so investors might well be wondering why they should bother seeking out green funds when the country is being steered in the opposite direction.
“Fixed income funds are also on the back foot, and rising bond yields in recent weeks suggest this sell off has accelerated. Bond markets are coming to terms with the possibility that interest rates might have to stay higher for longer, and that central banks aren’t simply going to keep delivering the monetary stimulus fix they became addicted to in the era of loose monetary policy. This also has implications for the stock market, which has been relatively sanguine about the risk-free rate of return rising by 4% in three years. Equity fund sales look relatively steady in August, but a secondary effect of rising bond yields could be tremors in the stock market too.
“One fund sector that can be relied upon to post large outflows come what may is UK equities. In August retail investors withdrew £1.1 billion from UK equity funds. There simply appears to be no bottom to this particular pit, and the government’s attempts to herd money into the UK stock market might well coincide with the last UK fund manager turning the lights out when they leave. There is some logical sense that can be attached to these long-lasting outflows. UK investors are still overweight UK shares when compared to the MSCI World Index, and many more global options now exist. It’s natural to expect a domestic bias in investors’ portfolios, though that has been significantly eroded in recent years by a combination of outflows and weak performance.
“Active funds as a whole are also under serious pressure. £354 million flowed into funds in August, with £1.6 billion going into tracker funds. The difference is made up of outflows from active funds. There is nothing new in this trend, though its relentless longevity is perhaps surprising. Passive funds have gone from less than 10% of industry assets ten years ago to over 20% today. The market needs active managers to allocate capital rationally and fund new issues, activities which shape the indices that passive funds follow. There is still plenty of money invested in active funds, but as passive funds continue to garner flows we can continue to expect money to flow into stocks based on their size, rather than any assessment of their fundamentals.”
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