Sustainable investing has come under some pressure over recent years. Back in 2022 many investors believed they could get the feel-good factor of investing sustainably without sacrificing investment returns. The past few years have shown otherwise, and returns have been more volatile, with some multi-asset sustainable strategies delivering a feast-or-famine experience. In the face of these performance headwinds some investors are, understandably, reassessing their investment priorities.
It is not just clients that have felt compelled to re-evaluate their investment strategy. Where fund managers and fund houses once proudly positioned their ESG credentials at the front and centre of every meeting we attended, sustainable business practices are now rarely featured unless prompted.
At the same time, the growing regulatory burden, and ever-changing terminology has increasingly become part and parcel of sustainable investing. The UKs new Sustainability Disclosure Requirements (SDR), which require firms to clearly label and explain the sustainability claims of their investment products is a good example – deadlines keep getting pushed back, terminology changes and staying on top of regulatory developments can be a full time job in of itself.
So, with weaker relative performance, more volatility, and heavier compliance demands, it’s no surprise that interest in sustainable portfolios has waned from its peak a few short years ago. After peaking in 2021 and 2022 (when ESG fund launches hit 340 globally in a single quarter) new activity has fallen sharply. In Q1 2024, just 64 new ESG funds were launched worldwide. The U.S. tells the same story, with launches dropping from 116 in 2022 to only 10 so far this year and some funds closing down entirely.
So how did we go from boom to bust? Time to dig into what’s been driving the struggles in sustainable investing.
Why exactly have sustainable funds underperformed?
There is no single reason, but one key factor is the restricted investment universe created by ESG screening. This makes building a fully diversified sustainable portfolio much more challenging than whole of universe approach.
ESG funds often favour tech, healthcare, and consumer-facing growth companies while underweighting traditional energy, defence, and heavy industry, sectors frequently excluded for poor ESG scores. Growth companies performed well until interest rates rose and markets rotated to value and cyclical sectors. Energy, a top-performing sector in 2022, is often underweighted in sustainable funds, which hurt returns.
Growth & Value Calendar Performance to 24/05/2025
Another factor is the underperformance of smaller companies relative to larger ones, especially in Europe and the UK. These regions’ indices are dominated by large energy and financial companies which are often excluded from sustainable portfolios. As a result, ESG funds lean more heavily on smaller, innovative companies in renewables and clean tech. These firms performed well before 2022 but have underperformed since, especially during the 2022 downturn.
European small caps vs large caps to 24/05/2025
This limited investable universe drives some of the more extreme swings in sustainable portfolio performance. Excluding entire sectors makes diversification harder, but it’s not impossible and the outlook may be more positive than recent history suggests.
A Brighter Future: Why Diversified Portfolios Can Still Shine
Despite recent headwinds, diversified sustainable portfolios have helped smooth volatility while unlocking fresh opportunities.
The hot air may be out of the market – and that’s a good thing.
After the hype and momentum-driven flows of 2021–2022, today’s sustainable investing landscape is leaner, more realistic, and arguably better positioned for long-term growth. With valuations reset and fundamentals back in focus, genuine opportunities are starting to emerge for patient, diversified investors.
Small Caps are Showing Signs of Life
European small and mid-cap stocks have rebounded this year with the MSCI Europe Small cap up approximately 13.5% this year (see above). Much of this has come from growth stocks which were fairly hammered in 2022, and this could suggest that many of these firms are undervalued.
Interest Rates and Valuations
Rising interest rates were a major headwind for growth companies, many of which are central to ESG strategies, as higher rates reduce the present value of future earnings. In fact, the sharpest period of underperformance for growth and small-cap names coincided with the most aggressive tightening cycle in decades.
Now, with inflation showing signs of moderation, central banks across key regions are shifting toward more accommodative policies. The ECB has cut rates from 4% to 2%, the Fed is signalling a pause or potential cuts later this year, and the Bank of England too, is cautiously actioning rate cuts. These moves are easing the pressure on growth-oriented companies, especially those focused on innovation and sustainability.
Takeaways for Sustainable Investors
Sustainable investing has faced challenges due to a more limited investment universe and sector biases, often resulting in concentrated portfolios overweight in growth-oriented small and mid-cap companies and underweight in sectors like energy and financials. This concentration can increase volatility and lead to periods of relative performance disparity.
Ultimately, while the sustainable investing is now having to compete on a similar risk/reward basis as all-encompassing strategies, the long-term drivers of sustainable investing remain intact, including global decarbonization efforts and increasing regulatory focus. In fact it’s fair to say that there is now a more industry wide pragmatism in this investment area with sectors such as nuclear power and even the much maligned defence sector being revisited.
A diversified sustainable portfolio that balances exposure across company sizes, sectors, and asset classes can help reduce volatility and keep clients with a sustainable mindset on the journey.
We are probably more optimistic about sustainable investing and not surprisingly our sustainable range in particular. We have seen an increased appetite based on our consistent investment characteristics, something that can be difficult to find in the sustainable space.
With over 16 years of experience and seven risk-profiled sustainable MPS portfolios, we have extensive research available. Contact the IBOSS team to learn more about our sustainable philosophy, SDR approach, and performance insights.
This communication is designed for professional financial advisers only and is not approved for direct marketing with individual clients. These investments are not suitable for everyone, and you should obtain expert advice from a professional financial adviser. Investments are intended to be held over a medium to long term timescale, taking into account the minimum period of time designated by the risk rating of the particular fund or portfolio, although this does not provide any guarantee that your objectives will be met. Please note that the content is based on the author’s opinion and is not intended as investment advice. It remains the responsibility of the financial adviser to verify the accuracy of the information and assess whether the OEIC fund or discretionary fund management model portfolio is suitable and appropriate for their customer.
Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise, and investors may get back less than they invested.
Data is provided by Financial Express (FE). Care has been taken to ensure that the information is correct but FE neither warrants, neither represents nor guarantees the contents of the information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Please note FE data should only be given to retail clients if the IFA firm has the relevant licence with FE.
IBOSS Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Financial Services Register Number 697866.
IBOSS Asset Management Limited is owned by Kingswood Holdings Limited, incorporated in Guernsey (registered number: 42316).
Registered Office is the same: 2 Sceptre House, Hornbeam Square North, Harrogate, HG2 8PB. Registered in England No: 6427223.
IAM 176.6.25