According to a report from Morningstar, ESG (Environmental, Social, and Corporate Governance) funds faced their worst year on record in 2023, as investors pulled out $13 billion. The pullout of investments marks the fifth straight quarter of net outflows and more than offsets the positive flows seen in Europe, dragging down the market globally.

Hennessy Funds Portfolio Manager of the Hennessy Stance ESG ETF (STNC) Bill Davis joins Yahoo Finance to discuss where ESG ETF investing stands and why he believes there are still some tailwinds that will help these funds bounce back.

Davis lays out why the loss is only a minor setback: "The underlying dynamics that are causing companies to more ambitiously decarbonize, focus on better governance, do all of the things that make them attractive from an ESG standpoint really aren't going anywhere. And, in fact, I would say if anything, institutional investors especially are stepping up their efforts to encourage companies to be more transparent and more ambitious. And I think if anything what's happening is the companies are simply using the term ESG less. But I think that the savvy ones understand that there's big opportunity in here, that there's opportunity to grab market share from competitors if they can develop new products and services that meet the demands of the market."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Editor's note: This article was written by Nicholas Jacobino

Video Transcript

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- 2023 marking the worst year on record for ESG funds, that's according to a new Morningstar report, as investors pulled $13 billion from US sustainable funds. Our next guest, though, sees tailwinds for this style of investing, with increasing concern about climate change and corporate governance. For more, we're talking now to Hennessy Stance ESG ETF Portfolio Manager, Bill Davis.

Bill, it is good to see you. And maybe we'll just start there with that headline, Bill, that ESG funds had their worst year on record that investors pulled around 13 billion from these funds in 2023. Bill, I'm just interested to get your take on, what do you think are the factors at play here? And what do you see for in 2024?

BILL DAVIS: Yeah, Josh, it's good to see you again. I think, first of all, 13 billion is not actually a lot of money in the grand scheme of things. And I think some of that was kind of a natural repositioning to be sure, ESG has faced some headwinds, I think in 2023.

However, I think that the underlying dynamics that are causing companies to more ambitiously decarbonize focus on better governance do all of the things that make them attractive from an ESG standpoint, really aren't going anywhere.

And in fact, I would say, if anything institutional investors, especially are stepping up their efforts to encourage companies to be more transparent and more ambitious. And I think, if anything what's happening is the companies are simply using the term ESG less.

But I think that the savvy ones understand that there's big opportunity in here. That there's opportunity to grab market share from competitors if they can develop new products and services that meet the demands of the market.

- Bill, I think you hit upon something really interesting here. Because obviously, there has been a noisy backlash against ESG as an investing strategy. And so as you said, maybe they're just not-- people are not or firms not using the term ESG in the same way, or they're being more quiet about it. Is that what's going on? How is that sort of playing out?

BILL DAVIS: Yeah. Jill, I think that's exactly how it's playing out. I think you see investment firms that rightly so had-- let's just call it, products that really weren't all that authentic, that have now backed away from referring to them as ESG products. And I think you've got large corporations.

And you can look, you can use a search term and just look for instances of mentioning ESG and you'll see the big companies are mentioning it less than they were a year or two ago. But that doesn't mean that the behind the scenes are not preparing for a future that could involve the SEC mandating what they need to disclose.

And even before that happens, actively preparing for what's going on in California around two different bills that have passed, one of which requires companies that are doing more than a billion in revenue to disclose, not only scope 1 and 2 but also scope 3 and then the other is to disclose physical transition risks. So, nothing is really changing, except for the fact that we're just being a little bit quieter about it.

- Well, Bill, let me ask you, though too about the role that politicians play here. At least, for some, Bill, as you all know, ESG has become a real-- it's become a punching bag. I mean, what kind of impact do you think that's having?

BILL DAVIS: Like, almost none. I mean, I think it's very difficult for everybody to sift through all of the mixed messaging. But I think that the performative politics aspect of it seems to be changing to me. This was like a campaign thing about nine months ago on the campaign trail. It's no longer a campaign thing, people don't even bring it up anymore.

And I also think it's worth noting that if you think about what ESG is at its core, it all really is a proxy for finding a well managed company. And on balance, if you have a choice between investing in say two beverage companies, and one of them is being super thoughtful around its relationship to the most important resource that goes into its product, let's just say that's water.

And the other one is ambivalent or oblivious to that. Which of those two companies are you going to invest in? So I think, at its heart all of the hubbub about ESG is partly well founded because there's a lot of product out there that really isn't particularly authentic. But a lot of it is just completely-- it's just all performative politics and it has nothing to do with what's really happening.

- So, Bill, let's get down to nitty gritty then fundamentals as to what you're looking for criteria wise when you're trying to figure out if a company does fit your ESG criteria? Especially as you say, are there more corporations that are paying attention to this right now. So do you have a sort of a bigger pool to draw from at this point?

BILL DAVIS: Yeah, so, Jill, we invest in the S&P 500. So in general, we are investing in the top half of every peer group that we can identify, and I think we've got about 66 of them right now within the S&P. And so with the exception of some categorical exclusions. For example, we do not invest in weapons tobacco or fossil fuels and we never have.

The reality is that really much-- half of every industry group is available to us other than that. And so we have a pretty big pool. I mean, if you consider what I just said, that's probably a couple hundred companies out of 504 that we can invest in at any given point in time.

I will tell you that the ESG behaviors don't really change that rapidly. Like, we're looking at data every quarter and we're getting real time data feeds from other organizations more frequently. But the reality is that ESG scores don't change that dramatically from quarter to quarter. So it's more the fundamental things that we're also looking at.

So in order to be in our portfolio, you need to be good from an ESG standpoint, or at least in the top half of your industry peer group. But you also need to be in the top 100 from the S&P as a whole around financial factors that we think are predictive of future performance over the upcoming quarter. So it's really you've got to be good at both to be included.

- Makes sense. Bill Davis, thanks so much. Really appreciate it.