The Financial Impact of Greenwashing on ESG Funds: Can Misleading Claims Lead to Underperformance?

Introduction

In recent years, Environmental, Social, and Governance (ESG) funds have emerged as a preferred investment avenue for individuals and institutions aiming to align financial goals with sustainability. However, these funds underperformed in 2024 and recently have come under scrutiny from both the public and regulators for misrepresenting their sustainability credentials. By analyzing fund performance data and recent reports of greenwashing practices in the ESG fund space, this article seeks to determine whether the underperformance is merely coincidental or a consequence of growing distrust fueled by misleading claims.

What is Greenwashing?

Greenwashing has become a significant concern in recent years as various instances have come to light. Some examples of this include misleading climate advertisements by HSBC and false carbon neutrality claims by Delta airlines. The term, famously coined by the environmentalist Jay Westerveld in 1986, is the intentional misrepresentation of an activity or product to showcase it as being more environmentally conscious or sustainable than it actually is. Greenwashing can manifest itself in various forms.  For example, a company publicly pledges to reduce pollutant emissions but never actually comes up with a plan to do so or labels products with vague terms such as “green” or “eco-friendly” without a concrete justification for doing so. Alternatively, greenwashing is promoting a sustainability initiative to draw attention away from the company’s harmful practices.  These deceptive practices are often difficult to identify, and they pose a serious threat to mitigating climate change.

Greenwashing by ESG funds

Recent reports have shown that many funds that market themselves as climate-specific are actually investing in fossil fuel and mining companies. As the return on some ESG investments can be quite low, some funds invest in them only with the intention of branding themselves as ESG funds, but also invest in high-return but environmentally harmful projects to offset this. How a fund is marketed is crucial, as investors rely on this marketing to make their investment decisions. However, the lack of transparency leads to the prevalence of greenwashing in the ESG fund space. Some funds market their ESG investments to attract environmentally conscious investors, while certain investments in their portfolio, such as those in companies that rank low on ESG metrics, are not highlighted. Despite proposals by the SEC to increase transparency and mitigate the practice of greenwashing, it is still an existing threat. The false social image created by greenwashing in ESG funds and the subsequent environmental harm are increasingly coming to light.

Recent trends in ESG fund performance

Mutual funds focused on sustainable investing and other ESG funds saw a drastic decline in investor interest. There was a record number of outflows in 2024 ($19.6 billion), along with the closing of several funds, while some funds opted to terminate their ESG mandates. There has clearly been a loss of investor interest in these funds. This contrasts with the surveys over the last few years that indicate a strong investor interest in sustainable and environmentally conscious investment decisions. Only 10 new funds were launched last year as opposed to 116 funds in 2022. Instead, 2024 saw 71 funds closing either through a merger or liquidation. This decline in ESG funds, despite investors’ environmental consciousness, might partly be a result of the declining confidence in these funds following reports of greenwashing.

Correlation between poor performance and greenwashing reports

Investors have only started to gain awareness about greenwashing in the last few years through increased media scrutiny and discourse among policymakers. Recent surveys have shown that 85% of institutional investors view greenwashing as a bigger problem today than it was five years ago. A majority of these investors even believed in the necessity of having better reporting standards and stated that there was a need to rebuild trust in ESG investments. Awareness among the public has grown recently through actions such as the SEC fine on WisdomTree Asset Management for greenwashing by lying to investors about the sustainability of its funds in 2024, the fine paid by the DWS group to the SEC for overstating its ESG efforts in 2023, and the settlement between Goldman Sachs and the SEC over greenwashing allegations within its ESG funds in 2022. These controversies and increased SEC regulations regarding greenwashing for ESG funds coincide with increased investment outflows for ESG funds. Studies conducted in the European Union and China have shown that greenwashing controversies can have a negative financial impact. Similarly, in the United States, there does exist a clear timeline link between ESG fund outflows and increased media scrutiny and investor awareness of greenwashing. This underpins the necessity of monitoring the impact of greenwashing on investors. There is a need to restore investor trust and safeguard the integrity of ESG investing.

Conclusion

The increasing risks of greenwashing are becoming widely known and have made investors more cautious. External factors have contributed, in part, to the current negative market trends of ESG funds; however, the correlation between the publicity given to greenwashing activities by funds and their underperformance is increasingly evident and should not be ignored. The role of ESG funds in promoting genuine sustainability can be restored by a better understanding the financial harm caused by greenwashing. It could lead to better self-regulation and honest practices by the financial institutions, or at least a stricter regulatory framework and enhanced transparency. A collective effort from regulators, fund managers, and investors is required to ensure that ESG investments remain a credible tool for driving positive environmental and social change.

Vedik is an LLM (Corporation Law) candidate at the NYU School of Law, where he serves as a Graduate Editor for the Journal of Law and Business. Prior to commencing his LLM, he interned at leading Indian law firms in the funds and general corporate practice areas. He graduated with a BBA LLB (Hons.) degree from OP Jindal Global University in 2024, where he worked as a teaching assistant and a research assistant on projects relating to investment fund regulation and green finance.