There's nothing like eye-popping returns to lure investors back into so-called ESG funds.
U.S. environmental, social, and governance funds saw inflows in the second quarter for the first time in more than three years, with electricity infrastructure and renewable energy themes behind much of the new cash.
It's too soon to call the net inflows into ESG funds, at just $3 billion, a turnaround -- yet it was their first positive quarter since the beginning of 2022, according to data from Morningstar. The combination of fresh cash and market appreciation lifted sustainable funds to nearly $400 billion, a new high.
The net inflows into ESG strategies were mostly limited to cheap, passive ETFs. Many active core-equity mutual funds saw outflows, with Parnassus Core Equity experiencing the most redemptions, at $1.9 billion for the second quarter. In all, passive ESG strategies saw inflows of $6.5 billion and active ones saw $3.6 billion in outflows, a moderation of recent trends.
A single fund supercharged much of the renaissance: the $12 billion First Trust Nasdaq Clean Edge Smart Grid Infrastructure exchange-traded fund. Through the end of July, it saw $5.5 billion in net inflows, says Ryan Issakainen, ETF strategist at First Trust, and had a one-year return of 32%.
The index based First Trust fund, which dates to 2009, covers a broad scope of the smart grid and electric infrastructure segments and has seen growing investor interest over the past 18 months, Issakainen says. It sits at a sweet spot for investors right now: growing demand for electricity from the artificial-intelligence buildout, more renewables being added to the electric grid, the need for infrastructure improvements after years of neglect, and energy security amid geopolitical tensions.
It isn't your typical ESG fund, he notes, since it lacks a sustainability mandate and exclusionary screens.
While 80% of the fund's holdings are pure-play smart-grid or grid infrastructure companies, another 20% are diversified companies, including some utilities that still operate natural-gas networks. They are selected for their transmission and distribution systems and grid-edge activity, which is where electric power meets the end user in battery storage and other devices.
Similarly, the $273 million First Trust Global Wind Energy ETF saw about $60 million in inflows in the second quarter. It also has no exclusionary screens, and 40% of its holdings are diversified companies involved in wind, which include several natural-gas utilities. Its one-year return is 30.7%.
A third clean-energy ETF, the $2 billion iShares Global Clean Energy, which has seen net inflows of $361 million year to date, screens out coal and oil but allows natural-gas electricity generation. Its one-year return is 35.9%.
Given the geopolitical tensions in the Strait of Hormuz and oil prices rising as high as $100 a barrel, it wasn't surprising to see clean energy and climate-action ETFs driving the flows, says Alyssa Stankiewicz, a manager research analyst at Morningstar.
Ron Pernick, managing director of Clean Edge, which creates the smart-grid and wind-energy indexes that the First Trust ETFs track, says the firm doesn't use ESG or sustainability screens but instead takes a broad look at how to capture a theme. The indexes are rules-based, and pure-play companies -- those with more than 50% of revenue from a theme -- get a bigger weighting.
"We are not sustainability screened, but we are looking at companies that are at the front end of these activities," he says.
Not every climate-action ETF that saw inflows in the second quarter had fossil-fuel holdings. The $1.3 billion Invesco Solar ETF and the $72 million iShares Energy Storage & Materials ETF don't hold fossil-fuel names but still boasted one-year returns of 44% and 69%, respectively.
It's also a reminder that sustainability means something different to each investor. Roraj Pradhananga, chief investment officer at Veris Wealth Partners, a sustainable and impact investment firm, says some of his clients view natural gas as a transition tool before the world moves to only renewable energy, while others shun fossil fuels completely and are willing to accept lower returns when that sector is outperforming.
While he builds customized portfolios and doesn't use the ETFs, Pradhananga says for fee-sensitive, do-it-yourself sustainable investors, these ETFs could be a good fit as the goal of these funds is to own companies moving in the direction of more renewable energy.
"There might not be a clear mandate, and there may be some contradiction in the holdings. But [in] public equities, we're always going to see contradictions," he says.
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