Investors are all for ESG. Except, that is, when times are tough

That, a recently published academic study finds, was the response of individual investors in ESG funds when the Covid-19 pandemic and lockdowns blindsided financial markets in early 2020.

Individual-investor demand for socially responsible investing “is highly sensitive to income shocks" and economic stress, concluded the study’s authors, Robin Döttling, an assistant professor of finance in the Rotterdam School of Management at Erasmus University in the Netherlands, and Sehoon Kim, assistant professor at the University of Florida’s Warrington College of Business.

The authors’ conclusions are a reminder that when times become tough for individual investors, not even the idea that they might be helping to save the planet from society’s excesses can persuade them not to sell investment products that they worry may suffer more in a downturn.

In contrast, the study found that demand for ESG investments—focused on environmental, social and corporate-governance issues—from institutions like pension funds and asset-management firms remained more robust. Those market participants, whose actions are shaped and often constrained by investment mandates, are usually slower to respond to market shocks and don’t face the same kind of pressures that individual households have had to grapple with during the Covid lockdowns and job losses.

Money matters

When an economic shock causes our incomes to shrink, we become more risk-averse. And, in the authors’ words, we start to view the emotional or nonfinancial appeal of ESG investing as “costly" and “unsustainable" if it means forfeiting returns.

“When you’re budgeting for your household, you have a different reaction than you might if your job is to develop asset-allocation plans and set return targets," says Alyssa Stankiewicz, associate director of sustainability research at investing-research firm Morningstar.

Of course, the spectacle of investors fleeing once-highflying market sectors is far from new; it dates back at least to the collapse of tulipmania in the Netherlands in the 17th century. Many of today’s investors can vividly recall watching the dot-com boom go bust at the beginning of the new century. And whenever headwinds appear, investors seek refuge in sectors they perceive as havens, and shun any that are revealed to have unexpected risk.

To reach their conclusions, the processors crunched their way through data about mutual-fund flows and conducted a survey about investor views of and expectations for sustainable investing.

The study focuses on the periods immediately before and after the pandemic hit worldwide in early 2020. It sheds light on the way that external shocks that wreak havoc on investors’ financial stability and income, rather than internal weaknesses in specific market sectors, can trigger selling pressure. While some pundits had worried publicly that a “green bubble" might come to a messy ending, the outflows studied by the two professors came in response to a global pandemic that may still be reshaping our views of risk and return.

Stress factor

Institutional players who also monitor ESG investment activity found the study’s results intriguing. “It reminds us that while investors want to express their values in their portfolios, in periods of distress and extreme volatility, they are also going beyond the ‘feel good factor’ to look at ESG from the point of view of risk mitigation and returns," says Sarah Hargreaves, head of sustainability at Commonwealth Financial Network in Waltham, Mass.

Still, Ms. Hargreaves warns that it may be difficult to extrapolate future trends from study results focused on a narrow window in time.

“It’s hard to say if we’re in a perpetually different environment" for investing in general and for ESG investing more specifically, she says. She does expect a new approach to ESG to emerge, but believes that this will be the result of more sophisticated analysis on the part of investors and increased regulation, rather than market or economic headwinds or trends.

Ms. Hargreaves also says that as 2022 drew to a close, shareholders once again were drawing up a raft of new ESG-related resolution in preparation for this year’s batch of corporate annual meetings. “The fund flows may become weak from time to time, but that’s not the only indicator" of individual interest in sustainability.

Meanwhile, Morningstar in late January released its own survey of ESG fund flows showing that on a global basis in the fourth quarter there were net inflows of $37 billion (compared with global outflows for all categories of $200 billion for the same period). Moreover, assets under management in this sustainable category grew 11.6% in the quarter to $2.5 trillion, ending three successive quarters of outflows. The picture in the U.S. was a bit murkier: The fourth quarter saw outflows of $6.2 billion, although flows were positive for the year as a whole.

While the impact of the pandemic on financial markets has abated, other headwinds have taken its place. Rising interest rates and high inflationnow are creating a different kind of income shock for investors, although it remains to be seen whether this will affect interest in ESG investing.

One possible outcome, suggested by the result of an online survey of 808 investors in the U.S. undertaken as part of the study by the professors, is that investors might be more willing to embrace ESG investing. Most said that they believed commitments to sustainability would be more important or as important as a source of financial value for corporations going forward compared with before the pandemic, while only 11.6% said such commitments would be less important.