For some people reading Morningstar’s latest Canadian Sustainable Funds Landscape Report, the headline findings of net outflows from Canada’s sustainable funds might raise a predictable question: are investors losing faith in ESG?

Between economic challenges, less-than-stellar performance of late, and other setbacks, that conclusion makes sense on its face. But it’s certainly not the one the author of the Morningstar report would jump to.

“For the year to the end of September, we’re still seeing net inflows of about $1.6 billion into Canadian sustainable funds,” says Danielle LeClair, director of Manager Research at Morningstar. “We also saw some outflows in the broad market … I would attribute this [third-quarter outflow] more to broader market trends than I would specifically to sustainable funds.”

Outflows amid a grey market backdrop

The $22.4 million in net outflows during Q3 marks the first period of redemptions from Canada’s sustainable funds in more than three years, going back to the second quarter of 2020. But as LeClair points out, the broader universe of Canadian long-term funds also lost nearly $4.1 billion during the recent third quarter.

To avoid double-counting of flows, the report’s methodology excludes funds-of-funds numbers. It’s difficult to be sure, but LeClair suspects at least some of the recent sustainable fund outflows are being motivated by shifts out of balanced funds, which make up more than 50% of mutual fund AUM in Canada.

Digging deeper, the report said Q3 also marked a second consecutive quarter of outflows for Canadian sustainable equity funds. Meanwhile, sustainable bond funds saw inflows for the third straight quarter and were the only recipients of net new money during the quarter, taking in nearly $506.2 million.

“That matches what you would expect. Given the market environment with higher yields, investors are taking another look at fixed income,” LeClair says. “Global equity funds saw the largest outflows, which makes sense because that’s the first are where we started to see a lot of ESG funds come out. Currently, about 20% of sustainable funds are global equity funds.”

Putting performance in perspective

Looking at sustainable funds’ performance, Morningstar found allocation funds and equity funds struggled most to perform in the third quarter, with 77% and 71% landing in the bottom half of their respective peer groups, respectively. The report also found 60% of allocation funds and 45% of equity funds were in the bottom quartile of their respective categories.

Zooming into the equity and allocation fund categories, LeClair said those with Canadian equity exposure – including all three Canadian balanced categories, as well as Canadian dividend and income, Canadian equity, and Canadian-focused equity – had the weakest results.

“Energy equity and global infrastructure equity also struggled,” LeClair says. “The Morningstar Canada Sustainability Index underperformed the Morningstar Canada index by 3.5% in Q3, so we did see from a Canadian equity perspective, sustainable companies underperformed their broad market peers.”

In Q3, energy emerged as the top-performing sector on a global basis. In Canada, where a larger chunk of the market is allocated towards energy, funds that screen out energy names from an ESG perspective underperformed as a result.

LeClair stresses that while there’s a tendency for energy names to be screened out from funds for ESG purposes, not all energy companies are ESG offenders, and there’s nothing to suggest the Canadian stock market as a whole is not ESG-friendly.

On the bright side of the sustainability picture, LeClair notes 13 new sustainable funds were launched in the third quarter, representing a continued healthy trend of growth. She’s also excited about the emergence of a more unified approach to try to speak about ESG, including the Canadian Institute of Fund Standards in Canada’s (CIFSC) six-category framework which was formally cemented in February.

“The terminology there is really helping asset managers build products that are really addressing investors’ unique ESG wishes or requirements, which makes it easier for investors to come to match their investing with their objectives,” she says.