The Analyst: why sustainable investing remains a viable strategy

Sustainable investing faces uncertainty and is raising concerns among investors about its future direction. Like any other investment theme, it follows cyclical trends. As such environmental, social and governance (ESG) focused strategies, once enjoying rapid growth, have recently lost momentum. Investors are now questioning when, or if, sustainable investing will return to favour.

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Sustainable investing is guided by ESG criteria such as climate change, health & safety in the working environment and protecting the interests of shareholders. Sustainable investing and ESG are often used interchangeably among investors.

Although the principle of sustainable investing dates back more than 50 years, the debate around the concept has intensified over the past few years. Some argue that it is in decline due to geopolitical change, regulatory scrutiny, and performance concerns. Others believe it is evolving rather than disappearing. While terminology and branding may shift, the underlying principles such as environmental risk management, ethical governance, and social responsibility will remain core to investing.

It is believed that in the long run, companies that run their businesses well, including managing ESG risks, should see that reflected positively in their valuations and may avoid risk events relating to ESG matters, such as reputational risk, stranded assets or workforce issues. As such sustainability and ESG are more transitional concepts before they become mainstream, helping companies incorporate these factors into core business strategies just like financial risks.  

Sustainable investments have experienced significant growth, which peaked during the Covid pandemic in 2020 and 2021. Fund managers were keen to launch new sustainable products or readjust existing portfolios to align with sustainability principles and take advantage of the wave of interest. Investor demand surged, driving record fund inflows, aided by strong performance and regulatory support.

Changing priorities

However, priorities began to shift over time, particularly following Russia's invasion of Ukraine in early 2022. Energy security concerns took precedence over long-term energy transition goals. Defence and arms investments, once excluded from ESG frameworks, were reconsidered. In addition, central banks began raising interest rates to tackle inflation, which particularly affected performance of many sustainable strategies biased towards growth assets.

As a result, ESG funds suffered underperformance, particularly when traditional energy stocks outperformed tech and renewable sectors in 2022. Some investors began questioning whether ESG criteria enhance financial performance or if they were primarily a marketing tool. As expected, along with poor performance, sustainable fund flows have been broadly negative since mid-2022. A lack of consistency and transparency in definitions and ratings has further complicated matters, making it difficult to measure the true impact of ESG on investments.

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This raised a lot of debate among investors about whether outperformance of sustainable versus conventional strategies was just a fluke and a result of bias to growth-oriented sectors such as technology.

The table compares the performance of ESG indices with conventional indices. Over the long term (five to 10 years), conventional indices consistently outperformed their ESG counterparts across all regions.

Source: Morningstar as at 28 February 2025. Total returns in GBP. P/E is price/earnings. P/B is price-to-book. Past performance is not a guide to future performance.

Trump goes cold on ESG

Looking at regulations around the world, while Europe continues to adopt sustainability disclosure requirements, the US has seen increasing politicisation of ESG. The re-election of US President Donald Trump in November 2024 only accelerated this trend. Key political figures, including Elon Musk have dismissed ESG as a “scam”.

In some states, such as Florida and Texas, restrictions on ESG-focused investments have been implemented, with arguments suggesting that they prioritise social goals over financial returns and act against the interests of business.

Since December 2024, major financial institutions, including Bank of America, Citigroup, and Morgan Stanley have exited the Net Zero Banking Alliance, citing regulatory uncertainty, political pressure, and legal risks. Beyond the financial sector, corporations such as Google and Meta have announced potentially scaling back diversity, equity, and inclusion (DEI) initiatives. Perhaps tellingly, Bloomberg recently reported that any talk regarding “climate” from execs on S&P 500 earnings calls has dropped by three-quarters over the past three years.

ESG trend not over yet

Nevertheless, some optimism still exists among investors. In Q1 of this year the People’s Pension, one of the UK’s largest multi-employer defined contribution schemes, decided to hand a £20 billion developed market equity mandate to Amundi and £8 billion of fixed-income assets to Invesco to run the funds “with a focus on responsible investment”. It retained just £5 billion with State Street, which had previously managed all its assets. Yet, despite facing ESG criticism, US fund managers such as BlackRock, Vanguard, and State Street still continue integrating sustainability into their investment strategies.

As ESG investing became popular, concerns about “greenwashing” intensified. Regulators in Europe are increasing scrutiny on companies exaggerating sustainability claims and misleading investors. This led to the regulatory landscape becoming more complex, with measures such as the European Union’s Sustainable Finance Disclosure Regulation (SFDR) and more recently the Sustainability Disclosure Requirements (SDR) in the UK, which have added further compliance challenges for fund managers and potential confusion for investors.

However, while sustainability and ESG has shifted from the investment agenda, the fundamental trends and risks that initially drove its rise such as climate change, social inequality, and corporate governance issues, remain real risks that investors cannot ignore. Regardless of ESG labelling, sectors such as renewable energy, electric vehicles, and sustainable infrastructure continue to attract substantial investment.

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For investors interested in sustainable investing, an ESG label alone is no longer a sufficient indicator. When doing their own research, they should look for genuine impact, transparency, and accountability from the business while staying vigilant against greenwashing. Evolving sustainability regulations such as SDR may increase short-term compliance burdens for fund managers, but they also present an opportunity to address past challenges, enhance transparency, and drive long-term positive change.

Sustainable investing may not be experiencing the explosive growth of previous years, but for many it remains a vital strategy. Investors should align decisions with their values and long-term priorities rather than reacting to market fluctuations or headlines.

For sustainable fund ideas check out our ACE 40 selection, which covers a range of asset classes and geographies. Whether you're looking to diversify your portfolio or start building a sustainable portfolio, our rated fund list can help you take the next step.