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European sustainable investment has enjoyed strong regulatory tailwinds © Bloomberg

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Interest in European exchange traded funds that invest according to good environmental, social and governance principles have held up better than non-ESG counterparts, despite concerns that sentiment might be cooling.

While ESG ETF inflows halved in the second quarter, relative to the first three months of the year, to €4.2bn, they fell by less than the European ETF market as a whole. As a result ESG ETFs represented 42 per cent of total ETF flows in Q2, compared with 30 per cent in Q1, Morningstar data show.

The rise of ESG has been buffeted by headwinds this year with the war in Ukraine increasing the attraction of western oil and gas and defence companies while ESG funds have also suffered from weak returns due to their overweighting of under-fire technology stocks.

“Despite the general recent underperformance of ESG investments, greenwashing concerns, and geopolitical events, we expect the strong demand for ESG and sustainable products to continue in the coming years,” said Hortense Bioy, global director of sustainability research at Morningstar.

Europe, which has enjoyed strong regulatory tailwinds, has led the world in ESG ETF investing. “The EU is leading the way with its Sustainable Finance Disclosure Regulation (SFDR) and taxonomy,” said Bioy.

She pointed out that in Europe, there was also a Mifid II regulatory amendment going live on August 2 that will require financial advisers to consider their clients’ sustainability preferences, in addition to their financial objectives. “This new piece of regulation has the potential to accelerate capital flows into sustainable and ESG funds,” Bioy added.

The Investment Association, a UK trade body representing the investment management industry, pointed out that funds across the board had been hit by falling markets, and that any resultant decline in investor interest was not exclusive to ESG funds.

“Our recent research on fund labelling found that investors are still interested in sustainable and responsible investing,” said Miranda Seath, head of market insight at the IA.

Nonetheless, the proportion of flows represented by sustainable ETFs was lower than last year, when in the first quarter of 2021 flows into ESG ETFs overtook flows into all other kinds of ETFs in Europe for the first time.

“I think the sentiment is less rosy than it used to be a year ago,” said Lana Khabarova, founder of SustainFi, an impact investing platform, although she said 42 per cent of flows was “still quite huge”.

Seath said IA research revealed investors were finding it difficult to navigate the growing range of sustainable funds available to them.

“It’s important that there is clarity and consistency in how our industry describes sustainable and responsible investment products to clients,” she said.

For some investors the cooling of their ESG ardour might just be a temporary hunt for better returns, according to Jose Garcia-Zarate, associate director of passive strategies research at Morningstar.

“The place to be this year is not necessarily ESG if you want to actually have returns,” Garcia-Zarate said. “Unfortunately, this is the year for fossil fuels.”

He said that even though ESG ETFs had not matched the standout performance achieved last year it would be “premature to say that ESG is losing ground”.

But this year might bring significant changes to what we define as ESG, he said, pointing to the recent contentious decision of the European parliament to designate gas and nuclear energy as sustainable.

“I can see how that will generate a lot of discussion,” he said. “The world of ESG might turn out to be very different.”

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