Why ESG Investing Might Never Recover

The ESG brand probably has its best days behind it.

Following a three-year craze for investment products focused on environmental, social and corporate-governance concerns, the percentage of newly created funds in the U.S. and Europe with ESG in their name has fallen from a peak of 8.3% to just 3.3%, according to an analysis of quarterly data by Morningstar Direct.

Likewise, online searches for “ESG investing” have plummeted back to mid-2019 levels, according to Google Trends. Mentions of the term in company analyst calls have dropped 59% from their quarterly peak in 2022, FactSet data suggest.

One explanation is the collapse of the clean-energy stocks most readily associated with the ESG movement. Flagging growth in electric-vehicle sales has hit sector behemoth Tesla . The S&P Global Clean Energy index, which lists solar-panel maker First Solar and Danish wind-turbine giant Vestas among its top constituents, has lost 31% since the start of 2023 as renewable-energy projects have been shelved. That compares with returns of 27% for global stocks.

The rise of ESG investing between 2019 and 2022 coincided with a surge in clean-tech valuations, and now the reverse is happening. Investors have pulled $2.2 billion from funds dedicated to decarbonisation since the start of the year, according to EPFR, and the outflows are getting larger every week.

There is a risk that ESG was an investment fad rather than a financial revolution extending across all industries.

The term was the product of an uneasy three-way alliance. On one side were ethically driven investors, who are particularly widespread in Scandinavia and include pension funds, universities and religious organisations united in wanting to shun contentious firms. On another were institutions such as the United Nations that aimed to channel money to industries that benefit society. Finally, there were investors who wanted to profit from the green revolution.

Asset managers jumped at the chance to cater to all three simultaneously. ESG allowed them to differentiate their products, revitalise the case for active management and, at a time of declining fees, charge more for stock screens that often lead to only small changes in allocations . Among U.S. equity funds, ESG strategies have an asset-weighted average fee of 0.52%, compared with 0.33% overall, Morningstar Direct data shows.

But the confusion of motivations made for contradictions and a lot of doublespeak. Neither ethical objectives nor bets on decarbonisation square logically with fund managers’ claims that ESG is a broad path to higher, safer returns.

Yes, an ESG focus can help active managers account for risks such as a regulatory backlash or governance blow up, which in some cases might be highlighted by new company disclosures. This month the European Union cleared the way toward requiring firms to better report and address sustainability impacts.

However, the assumption that integrating ESG criteria into their screening will lead to better stock picking seems flawed . The very popularity of ESG makes it unlikely that the market is under appreciating the risks. The rush of money into firms like Vestas, whose stock hit a price-to-earnings ratio of 534 in 2022, illustrates the risk that shares with high sustainability scores can get too expensive, leading to lower returns.

Ethical investors might be fine with this, but that just shifts the focus to what counts as ethical. Tellingly, interest in ESG has dropped more in the U.S., where the politicisation of EVs and culture wars surrounding Bud Light beer show how easily corporations can become ideological battlegrounds.

ESG ratings aren’t much help in navigating these issues. Different providers give wildly different scores to the same companies, even within the specific “E,” “S” and “G” factors, according to a February paper by the Leibniz Institute SAFE. Researchers also found that environmental concerns tend to explain most of the overall score.

This is another hint that the ultimate driver of the pandemic-era ESG craze might have been a hunger for thematic investment. It has since found better sources of sustenance, as demonstrated by the breakneck growth of firms such as Global X, which is delivering increasingly granular offerings such as tracker funds for electric batteries, cloud computing and ageing populations.

Buyers of these products can be fickle and jump to the next theme—often too quickly for their own good, a Morningstar analysis showed last November. It is possible that the overly generic ESG brand will never recover its appeal, with the different parts of it eventually rebranded to suit their specific client bases. BlackRock , the world’s largest asset manager, has already dropped it and is now emphasising transition themes over ethical stewardship of companies.

Sustainable investing isn’t going anywhere. But a broad tent covering too many interests serves none of them well.

For years, global companies showcased their Chinese operations as a source of robust growth. A burgeoning middle class, a stream of people moving to cities, and the creation of new services to cater to them—along with the promise of the further opening of the world’s second-largest economy—drew companies eager to tap into the action.

Then Covid hit, isolating China from much of the world. Chinese leader Xi Jinping tightened control of the economy, and U.S.-China relations hit a nadir. After decades of rapid growth, China’s economy is stuck in a rut, with increasing concerns about what will drive the next phase of its growth.

Though Chinese officials have acknowledged the sputtering economy, they have been reluctant to take more than incremental steps to reverse the trend. Making matters worse, government crackdowns on internet companies and measures to burst the country’s property bubble left households and businesses scarred.

Lowered Expectations

Now, multinational companies are taking a hard look at their Chinese operations and tempering their outlooks. Marriott International narrowed its global revenue per available room growth rate to 3% to 4%, citing continued weakness in China and expectations that demand could weaken further in the third quarter. Paris-based Kering , home to brands Gucci and Saint Laurent, posted a 22% decline in sales in the Asia-Pacific region, excluding Japan, in the first half amid weaker demand in Greater China, which includes Hong Kong and Macau.

Pricing pressure and deflation were common themes in quarterly results. Starbucks , which helped build a coffee culture in China over the past 25 years, described it as one of its most notable international challenges as it posted a 14% decline in sales from that business. As Chinese consumers reconsidered whether to spend money on Starbucks lattes, competitors such as Luckin Coffee increased pressure on the Seattle company. Starbucks executives said in their quarterly earnings call that “unprecedented store expansion” by rivals and a price war hurt profits and caused “significant disruptions” to the operating environment.

Executive anxiety extends beyond consumer companies. Elevator maker Otis Worldwide saw new-equipment orders in China fall by double digits in the second quarter, forcing it to cut its outlook for growth out of Asia. CEO Judy Marks told analysts on a quarterly earnings call that prices in China were down roughly 10% year over year, and she doesn’t see the pricing pressure abating. The company is turning to productivity improvements and cost cutting to blunt the hit.

Add in the uncertainty created by deteriorating U.S.-China relations, and many investors are steering clear. The iShares MSCI China exchange-traded fund has lost half its value since March 2021. Recovery attempts have been short-lived. undefined undefined And now some of those concerns are creeping into the U.S. market. “A decade ago China exposure [for a global company] was a way to add revenue growth to our portfolio,” says Margaret Vitrano, co-manager of large-cap growth strategies at ClearBridge Investments in New York. Today, she notes, “we now want to manage the risk of the China exposure.”

Vitrano expects improvement in 2025, but cautions it will be slow. Uncertainty over who will win the U.S. presidential election and the prospect of higher tariffs pose additional risks for global companies.

Behind the Malaise

For now, China is inching along at roughly 5% economic growth—down from a peak of 14% in 2007 and an average of about 8% in the 10 years before the pandemic. Chinese consumers hit by job losses and continued declines in property values are rethinking spending habits. Businesses worried about policy uncertainty are reluctant to invest and hire.

The trouble goes beyond frugal consumers. Xi is changing the economy’s growth model, relying less on the infrastructure and real estate market that fueled earlier growth. That means investing aggressively in manufacturing and exports as China looks to become more self-reliant and guard against geopolitical tensions.

The shift is hurting western multinationals, with deflationary forces amid burgeoning production capacity. “We have seen the investment community mark down expectations for these companies because they will have to change tack with lower-cost products and services,” says Joseph Quinlan, head of market strategy for the chief investment office at Merrill and Bank of America Private Bank.

Another challenge for multinationals outside of China is stiffened competition as Chinese companies innovate and expand—often with the backing of the government. Local rivals are upping the ante across sectors by building on their knowledge of local consumer preferences and the ability to produce higher-quality products.

Some global multinationals are having a hard time keeping up with homegrown innovation. Auto makers including General Motors have seen sales tumble and struggled to turn profitable as Chinese car shoppers increasingly opt for electric vehicles from BYD or NIO that are similar in price to internal-combustion-engine cars from foreign auto makers.

“China’s electric-vehicle makers have by leaps and bounds surpassed the capabilities of foreign brands who have a tie to the profit pool of internal combustible engines that they don’t want to disrupt,” says Christine Phillpotts, a fund manager for Ariel Investments’ emerging markets strategies.

Chinese companies are often faster than global rivals to market with new products or tweaks. “The cycle can be half of what it is for a global multinational with subsidiaries that need to check with headquarters, do an analysis, and then refresh,” Phillpotts says.

For many companies and investors, next year remains a question mark. Ashland CEO Guillermo Novo said in an August call with analysts that the chemical company was seeing a “big change” in China, with activity slowing and competition on pricing becoming more aggressive. The company, he said, was still trying to grasp the repercussions as it has created uncertainty in its 2025 outlook.

Sticking Around

Few companies are giving up. Executives at big global consumer and retail companies show no signs of reducing investment, with most still describing China as a long-term growth market, says Dana Telsey, CEO of Telsey Advisory Group.

Starbucks executives described the long-term opportunity as “significant,” with higher growth and margin opportunities in the future as China’s population continues to move from rural to suburban areas. But they also noted that their approach is evolving and they are in the early stages of exploring strategic partnerships.

Walmart sold its stake in August in Chinese e-commerce giant JD.com for $3.6 billion after an eight-year noncompete agreement expired. Analysts expect it to pump the money into its own Sam’s Club and Walmart China operation, which have benefited from the trend toward trading down in China.

“The story isn’t over for the global companies,” Phillpotts says. “It just means the effort and investment will be greater to compete.”

Corrections & Amplifications

Joseph Quinlan is head of market strategy for the chief investment office at Merrill and Bank of America Private Bank. An earlier version of this article incorrectly used his old title.

Why ESG Investing Might Never Recover

The appeal of the moniker is waning, probably because it is trying to serve too many interests at once

Multinationals like Starbucks and Marriott are taking a hard look at their Chinese operations—and tempering their outlooks.

Lowered Expectations

Behind the Malaise

Sticking Around