Why ESG Funds Fail to Scale

Illustration by Matt Chinworth

Illustration by Matt Chinworth

Most ESG managers struggle to get investors’ attention. Here’s why.

You’ve seen the headlines about the growth in environmental, social, and governance funds.

Many investment professionals might read these and believe that launching a new ESG investment firm or ESG offering will be an automatic success. Our analysis of the data shows that this is far from the truth: Most of these efforts fail.

There are good reasons for that. So what can we learn from those that fail and those that succeed?

Drivers of Growth

There is a good explanation for why we’ve seen an increase in the supply of ESG funds: demand.

We identify four key forces driving that demand. First, data availability on ESG topics has grown substantially richer over the past years, with data quality also improving. This has allowed asset owners and regulators to ask managers ESG-related questions. It has also enabled more managers to analyze at scale the impact of ESG considerations on a portfolio’s performance and characteristics.

Second, accumulating evidence that ESG issues are financially material has empowered managers to position ESG integration as part of a rigorous investment process and refute the past misconception that ESG is about investing just on the basis of values.

Third, societal pressures have led asset managers to want to better understand how companies behave before including them in their portfolios, to ensure alignment with normative principles (e.g., human rights). Managers have increasingly been scrutinized for holdings that made headlines for the wrong reasons, generating reputational nightmares.

Last, investors have realized that they can utilize the power of capital to alter unsustainable corporate behavior and help solve the world’s most agonizing problems, like climate change.

All of these developments have attracted managers’ attention in recent years. As a result, the number of investment managers that have signed on to the United Nations’ Principles for Responsible Investment reached 2,245 as of September 20, with about 66 percent of them having joined in just the past five years (Figure 1). These managers may be running socially responsible investment funds (largely based on exclusions of certain industries and/or revenue-generating activities) or impact funds (specifically targeting ESG outcomes). Other funds might integrate ESG analysis alongside traditional financial analysis, to enhance returns and/or reduce the regulatory and reputation-related risks of their portfolio companies.

Snapshot of the ESG Fund Landscape

As more managers signed on to the PRI, the market became flooded with ESG investment solutions. As of 2018 the Global Sustainable Investment Alliance reported that about $30.7 trillion was allocated to sustainable investing assets. This figure has more than doubled from roughly $13.3 trillion in 2012.

The growth in the number of ESG funds has been equally impressive. Using Refinitiv’s database for funds under the Ethical category (defined as those whose investment criteria include ethical and social concerns; Refinitiv does not currently classify funds under an ESG category per se), we find that there are currently 6,618 publicly available investment products incorporating ESG-related topics in one form or another. Their total size is roughly $2.6 trillion. Of these funds, 54 percent are allocating capital in the public equity asset class, representing about 53 percent of the total size.

The pace at which ESG funds have been launched over the past several years is striking. The oldest fund in the database is Amundi’s Pioneer Fund, which launched in 1928. It was followed by Robeco’s Sustainable Global Stars Equity Fund in 1938 and UBS’s Switzerland Sustainable Fund in 1949. The real boom in ESG funds started in 2012, with more than 40 percent of all ESG funds launched over just the past five years (Figure 2). Of the funds available, about 60 percent are domiciled in Europe, and about 40 percent have a global geographical focus for their investments. Managers have responded unequivocally to client demand with new products.

We often see headlines stating that the world’s richest 1 percent own 44 percent of the world’s wealth. The same dynamic is true for the distribution of assets among ESG funds. Our data sample suggests that 57 percent of the funds have assets under management of less than $100 million. About 73 percent have less than $250 million. Only 0.9 percent of the funds have more than $5 billion. These dynamics hold true for all asset classes (Figure 3). Furthermore, the sample’s top 1 percent of funds by size have accumulated about 26 percent of the assets, with the top 10 percent accounting for 70 percent of the total capital allocated to ESG funds. Critically, the bottom quartile of funds by size accounts for just 0.3 percent of the assets under management (Figure 4).

This is a highly fragmented market, where most of the managers are struggling to get the attention of allocators and grow the size of their offerings to sustainable levels.

Drivers of Fragmentation

We believe the reasons behind this dynamic can be attributed to a few inherent characteristics of the investment market:

1. Lack of a sufficiently long live track record: Institutional investors and distribution partners often have policies in place that prohibit them from investing in funds with live track records of less than three, or in some cases five, years. The rationale is that a sufficiently long track record helps investors get more comfortable with the performance of the strategy, as well as the manager’s ability to handle fund operations. With most ESG funds having been launched just recently, they would not qualify for investment. Unfortunately, there is nothing that can be done to speed up time. However, given that under every performance figure ever reported there is a disclaimer that “past performance is no guarantee of future results,” investors may wish to apply critical judgment and focus more on a manager’s investment philosophy and approach to achieving the desired objectives.

2. Small size: This is a controversial argument, but it is one hundred percent factual. Effectively, the reason many funds remain small is that they are currently small. Institutional investors and distribution partners normally require funds to be of a minimum size. Usually, $100 million or $250 million is the magic number, but the requirement may be as high as $1 billion. The reasoning is that, by policy, an investor may not be allowed to hold more than a certain percent of the total fund (often a quarter or a third). At the same time, institutional investors’ typical allocations are $50 million to $100 million. This is because any smaller allocation does not materially impact the profile of a portfolio enough to justify the effort of onboarding a new fund. Thus, before allocators are allowed to invest in a fund, the fund needs to already be about $200 million in size. Similarly, distribution partners are not keen on running the risk of the fund’s failing to grow to a financially sustainable size and thus having to be liquidated. Last, size provides investors with the comfort and reassurance that a fund has been reviewed and approved by other investors that have performed extensive due diligence on the manager and the strategy. As is often said, it is easier and safer to copy and follow rather than to lead. This, unfortunately, is a chicken-and-egg problem. Too many managers have opportunities that are dependent on another, which in turn is dependent on the former. And because one is waiting for the other, at the end no investment takes place.

3. Newcomers: A lot of the management firms specializing in ESG investing have been launched relatively recently. As is true in every industry, competing with the well-known, established companies is a real challenge. This is even truer in the financial industry, where the risk to an allocator of losing his job because he invested in a manager that no one had heard of before is high. Brand does matter. In the financial industry a trusted brand provides reassurances that are critical in the allocation decision process. An established asset manager does not have to try too hard to justify why and how he can attract the best of human capital to work on a new strategy. It is assumed that big budgets have been allocated to acquire the best and most complete data, and that the strategy has been scrutinized by experienced professionals from the moment the idea was conceived. For younger firms the journey is much more difficult. Before they even get the opportunity to dive into a strategy, they need to explain their own financial positions and elaborate on the unique aspects they bring onboard versus the established players. At the end, allocators have a fiduciary duty to their investors and need to account for all types of risk associated with investing in a new firm. Surely, some sophisticated investors are running emerging manager programs to support new firms with great ideas. But the vast majority of institutional investors and distributors tend to prefer investing with established names to minimize “emerging” risks.

4. Performance: Implementation of ESG strategies may vary widely among managers. In some cases, managers may incorporate ESG considerations into company valuations or portfolio optimizations, whereas others may just be reaching for the low-hanging fruits of “ESG compliance.” In an attempt to be eligible for ESG allocations and not miss out on the trend, many managers launched funds in a hurry, without really researching what ESG investing truly is. Institutional investors have a fiduciary duty, first and foremost, to safeguard the financial interests of their beneficiaries. They are empowered, though, with the tools (i.e., capital allocation decisions) to support the integrity and stability of the whole financial system, reward responsible corporate behavior, and have an impact on global issues. Funds that deliver on their ESG promises without compromising their financial potential will be the ones with the higher chances to be successful.


The primary aim for a small fund is to reach the critical size milestones of $100 million and $250 million as soon as possible. Those thresholds unlock a lot of opportunities that otherwise are just not feasible. We believe that by following the five suggestions below, managers can maximize their chances of addressing the aforementioned obstacles:

1. Be authentic in your ESG approach: To differentiate yourself in this fast-growing competitive market, your approach to ESG investing should be genuine and not a simple box-ticking exercise. Top executives, portfolio managers, ESG specialists, and client representatives need to understand (a) why ESG is important for your firm as a market actor, (b) how it is affecting portfolio performance, and (c) why it is relevant to your clients. ESG strategies often are put together by taking the “original” portfolio constructed by the investment team and then excluding poor performers as suggested by the ESG team. To use an analogy, this is like a vegetarian ordering a beef burger and then just removing the patty; it certainly will not taste as good as a properly prepared vegetarian meal. Similarly, sustainability behavior is guided by the culture of a company and the way it operates at the cellular level — a notion called corporate philotimy. This in turn defines strategy, which can be quantified by ESG metrics. Thus the disconnect between investment and ESG teams is unreasonable. Investment professionals need to understand the dynamics between ESG and financial performance and to talk about ESG investing not as a separate theme, but as Corporate Finance 2.0. Such an authentic approach will address the performance obstacle. At the same time, giving experienced professionals with successful personal track records responsibility for the design of the investment strategy will further mitigate track record concerns for the fund.

2. Get the narrative right: Every strategy has an investment objective. That may be to maximize absolute performance or risk-adjusted performance, minimize volatility and/or drawdowns, or maximize ESG outcomes. Managers and client-facing personnel need to be crystal clear on a strategy’s priorities and how they can be achieved. Crucially, when it comes to sophisticated institutional investors and financial advisers, managers need to explain what void a strategy is filling. One of the major challenges for allocators is that when they are presented with an ESG strategy, they are unclear on the “bucket” in which they can allocate to it. Typically, allocations are based on factor exposures like core, value, growth, and momentum; asset classes; geographical exposures; and combinations of those. Conveying a well-articulated message — for example, “This is a European midcap public equity strategy that targets value risk premia while holding companies whose operations do not contribute to global temperatures rising above 2 degrees Celsius” — immediately helps an investor to understand where the strategy fits in his portfolio. Critically, you will need to demonstrate that targeting ESG objectives does not negatively affect financial performance. By positioning your strategy in a manner that addresses a client’s specific needs, you distinguish your offering from others’ and use the “newcomer” obstacle to your advantage.

3. Educate your clients: The realms of corporate sustainability and ESG investing are relatively new. However, in a very short period of time, they have managed to attract significant amounts of attention from academics and market participants. Academic research on ESG topics is growing very fast. At the same time, various initiatives with the objective of addressing ESG-related topics are continually being launched. Regulation is ever evolving, targeting both corporate and investor behavior. This is a lot for someone to keep up with —especially if this is not his or her core job. Here is where you, as an ESG manager, have an opportunity to differentiate your overall service and make your clients’ lives easier while positioning yourself as an expert. By concisely summarizing new, material developments related to ESG issues, you can help clients navigate this information overload. You become the go-to person for any questions they may have on ESG. It is likewise important to produce your own thought leadership pieces. It is your chance to articulate what differentiates you from peers and the research capabilities you bring to the table. By doing so, you again use the “newcomer” obstacle to your advantage and mitigate track record–related concerns by establishing yourself as an expert in the field.

4. Share impact reports: Given that ESG considerations are among the factors affecting your allocation decisions, investors expect you to elaborate on their impact on the portfolio’s performance. Providing answers to questions like “Were ESG characteristics a positive or a negative contributor to return and risk?” and “How much of the excess relative performance can be attributed to ESG?” enhances transparency and helps investors understand the importance of ESG integration, as well as any associated trade-offs. But impact reporting (especially for ESG funds) should not exclusively focus on financial metrics; it should also address societal ones. ESG reporting for investment funds is still under development. Some managers now provide an overall ESG score for a fund as calculated by one of the ESG ratings providers. Those scores are the most basic information a fund could provide, but because of their lack of meaning and transparency, they are of little help. A somewhat more advanced form of impact reporting could involve disclosing the performance of a fund on certain ESG topics (e.g., carbon emissions, CEO pay, diversity metrics) versus an appropriate benchmark. For more specialized strategies, such as those specifically aimed at addressing climate change, adopting a reporting framework in line with the appropriate metric providers — in this example, the Task Force on Climate-Related Financial Disclosures — would be important to illustrate that you are meeting the strategies’ goals. Ultimately, reporting should reflect the portfolio’s financial, social, and environmental performance, transparently capturing environmental, employment, and product impacts as described by the Impact-Weighted Accounts Initiative. In other words, a comprehensive report should disclose the impact-weighted profitability of the portfolio relative to the impact-unweighted one. By transparently disclosing details of your portfolio’s impact, you are again differentiating your offering and, critically, gaining credibility as an expert in the field, mitigating track record–related concerns.

5. Know your Audience: At the beginning, it is important to allocate your resources prudently and focus on attracting clients who are most likely to support you at this early stage. Approach clients for whom your strategy serves as a solution to gaps in their portfolios and concerns they have already identified. When it comes to sophisticated institutional allocators, understand their stance on ESG investing. Is there top-management support? Have they made public commitments on ESG integration? Have they made unfavorable headlines for ESG-related reasons? Is the regulatory environment urging them to increase allocations to ESG funds? Explain why your solution is relevant to them and how it can help them to achieve their objectives. Further, move away from the thinking that one or two investors will bring the fund to the desired asset levels. Focus on smaller opportunities that are more likely to materialize. For example, family offices tend to have more relaxed requirements and a greater appetite for innovation than bigger institutional investors. Importantly, their client bases may have strong views on ESG concerns, and they might like to see their investments having an impact on them. By “knocking on the right doors,” you are increasing your chances of solving the chicken-and-egg problem.


On August 2019 the leaders of the world’s biggest corporations signed a declaration stating that the purpose of a company is beyond profit. Larry Fink, the CEO of BlackRock — the world’s biggest asset manager, with assets under management of more than $7 trillion — sent a letter to CEOs in January 2020 asserting that “a company cannot achieve long-term profits without considering the needs of a broad range of stakeholders.” In October 2020 the IFRS Foundation, the organization hosting the work of the International Accounting Standards Board, which guides financial reporting in 144 jurisdictions, issued a request for comments on a proposal to create a sustainability standards board. A group of 33 institutional investors, representing a combined $5.1 trillion of assets, have committed to transitioning their investment portfolios to net-zero greenhouse gas emissions by 2050.

All of this is an indication that the attention to ESG investing has never been bigger and that investors will keep increasing their allocations to ESG funds. There has thus been a dramatic increase in the quality of human capital attracted by sustainable finance. Professionals with advanced skills and diverse experiences are now entering a realm that had been considered niche. They will be applying those skills to allocating capital in a manner that will finance and support sustainable corporate strategies, as well as purpose-driven organizations helping to address the world’s most pressing issues. Consequently, the probability of success for ESG fund managers will increase.

So, though it might be easier to get frustrated and throw in the towel, it is crucial to learn from the past, acknowledge this unprecedented opportunity, and position sustainability at the core of your investment philosophy in order to emerge victorious.

Gabriel Karageorgiou is a partner at Arabesque Asset Management. George Serafeim is the Charles M. Williams Professor of Business Administration and the faculty chair of the Impact-Weighted Accounts Project at Harvard Business School. In 2013, along with Sakis Kotsantonis, they co-founded ESG consulting firm KKS Advisors.