In 2020, ESG was the golden acronym of investing. Environmental, Social, and Governance criteria were seen as not just ethical considerations, but intelligent screens for long-term resilience and outperformance. Fast forward to 2025, and the narrative is more complex. ESG funds are underperforming major benchmarks like the S&P 500 and Nasdaq, and investors are starting to wonder whether the promise of doing well by doing good is cracking under pressure. So what happened—and does ESG still deserve a place in your portfolio?
The Numbers Don’t Lie: ESG Returns Lag Broad Indexes
In the post-pandemic bull market, ESG funds gained momentum as global liquidity and investor sentiment aligned with climate goals and social responsibility themes. But recent years have delivered a harsh dose of reality. ESG indices have notably trailed traditional equity benchmarks, especially those dominated by tech giants and energy companies. The MSCI World ESG Leaders Index is underperforming the broader MSCI World Index in 2024 and 2025. Several high-profile ESG ETFs have delivered lower annualized returns than plain vanilla index funds.
This underperformance is not anecdotal—it’s structural. ESG portfolios often underweight fossil fuels, defense contractors, and companies with weaker governance scores, many of which have been among the top performers in the current macro environment. At the same time, ESG-tilted funds have been overweight green energy, tech, and consumer names, sectors that faced cyclical and valuation headwinds.
Energy Markets and the ESG Paradox
Perhaps the most glaring drag on ESG performance has been energy. As oil prices surged following geopolitical disruptions—from Ukraine to the Red Sea—traditional energy stocks like ExxonMobil and Chevron soared. ESG funds, often restricted from owning these companies due to carbon footprint considerations, missed out.
This created an awkward paradox: funds designed to promote sustainability were punished for excluding companies that thrived in an unsustainable environment. Meanwhile, renewable energy stocks, once market darlings, struggled under rising interest rates, supply chain bottlenecks, and policy delays. The result? ESG underperformed precisely when energy was booming.
Moreover, many ESG funds faced pressure to divest from nuclear and defense sectors—industries that in 2025 are increasingly recognized as vital to national security and energy stability. These exclusions further widened the performance gap between ESG strategies and the broader market.
The Governance Puzzle: Intentions vs. Outcomes
Governance, the “G” in ESG, was supposed to protect investors by favoring companies with transparent leadership, sound audit practices, and strong boards. In theory, this should lead to lower risk and higher returns. But real-world implementation has been messy.
Some ESG funds applied governance screens inconsistently, excluding firms based on controversies without distinguishing between isolated incidents and systemic failures. Others held on to high-scoring governance companies that nevertheless delivered poor stock performance. In 2025, investors are beginning to realize that good governance doesn’t guarantee alpha—it just reduces tail risks.
What complicates matters further is that ESG ratings vary wildly depending on the provider. One firm’s ESG leader is another’s laggard. Without standardized criteria, funds are vulnerable to “greenwashing”—holding companies that appear ESG-compliant on the surface but lack genuine sustainability practices.
Social Metrics Are the Hardest to Quantify
Social factors—like diversity, labor practices, and human rights—are arguably the most subjective and hardest to quantify. Unlike carbon emissions or board independence, social impact metrics lack a universally accepted measurement framework. This makes ESG scoring uneven and the investment case weaker.
In 2025, major tech companies continue to score well on ESG despite facing criticism over AI ethics, labor outsourcing, and content moderation. Meanwhile, firms with strong social missions but limited disclosure fall off the ESG radar. This disconnect between qualitative impact and quantifiable metrics is eroding confidence among institutional and retail investors alike.
Is ESG Just a Marketing Label Now?
Critics argue that ESG has become more of a marketing term than a rigorous investment philosophy. Asset managers launched a flood of ESG-labeled products during the 2020–2022 boom, often without significantly altering underlying asset allocations. The result: many funds simply rebranded existing portfolios to attract inflows without meaningfully improving sustainability performance.
Now, with returns trailing and regulators scrutinizing greenwashing, investor trust is wavering. Retail investors feel duped, and even institutional allocators are rethinking their mandates. Some sovereign wealth funds and pension managers are scaling back ESG exposure, citing unclear performance attribution and misaligned incentives.
Macro Headwinds: Inflation, Rates, and Policy Shifts
Beyond sector and selection issues, ESG investing has faced macroeconomic headwinds. Higher interest rates have hurt growth stocks, which dominate ESG portfolios. Inflation has shifted investor focus toward hard assets and cash-generative businesses—again, areas ESG often avoids.
In addition, ESG-friendly government policies have lost momentum. While climate pledges remain in place, actual implementation has slowed amid political pushback, budget constraints, and voter fatigue. Europe’s ESG disclosure laws are advancing, but the U.S. remains divided. In emerging markets, ESG is still largely a top-down directive, with limited grassroots traction.
Without policy tailwinds or fiscal incentives, ESG strategies now have to compete purely on fundamentals—and in 2025, that’s proving difficult.
Should You Still Care About ESG?
Despite the performance slump, dismissing ESG entirely would be short-sighted. Many of the structural drivers behind ESG investing remain intact. Climate risk is real. Labor transparency matters. Cybersecurity, diversity, and long-term governance are increasingly priced into valuations. The problem isn’t ESG’s goals—it’s the implementation.
For long-term investors, ESG principles can still add value if applied selectively and thoughtfully. Rather than relying on generic ESG funds, consider building your own screen based on factors you actually care about—carbon exposure, board diversity, or labor practices. Use ESG as a tool, not a label.
It’s also worth considering a shift toward “ESG 2.0”—an evolved framework that prioritizes materiality over virtue signaling. That means focusing on ESG factors that directly impact a company’s financial performance rather than ticking every ethical box. For example, emissions metrics may be critical for energy and logistics companies but less relevant for software firms. The key is context, not compliance.
Emerging Approaches: Active ESG and Thematic Funds
To improve outcomes, some investors are turning to active ESG strategies that dig deeper into company fundamentals and sustainability roadmaps. These funds rely on active engagement—pressuring companies to improve disclosures, set net-zero targets, and reform governance structures.
Another emerging trend is thematic ESG investing. Instead of broadly ESG-labeled funds, investors are targeting specific themes like clean water, sustainable agriculture, or circular economy. These strategies offer more targeted exposure and clearer impact alignment.
Additionally, climate transition funds are gaining popularity. These funds don’t exclude fossil fuel companies entirely but instead invest in firms making meaningful steps toward decarbonization. This pragmatic approach may yield better returns while still supporting ESG goals.
The Global Picture: ESG Isn’t Dead—Just Evolving
Around the world, ESG is evolving. In Europe, regulation is tightening and investor demand remains strong, though performance concerns are rising. In the U.S., ESG is caught in a political tug-of-war, but some blue states and large pension plans continue to push ahead. In Asia, ESG is expanding via corporate governance reforms, especially in Japan and South Korea.
What’s clear is that ESG’s blanket popularity has faded, replaced by a more nuanced, sometimes skeptical approach. But it would be a mistake to assume ESG is a fad. It’s more likely undergoing a necessary transition from hype to substance.
Conclusion: ESG’s Midlife Crisis or Maturity Moment?
The underperformance of ESG funds in 2025 is real—and should not be ignored. But it doesn’t mean the concept is dead. Like any investment strategy, ESG needs to adapt to macro conditions, clarify its goals, and align with investor expectations.
Rather than chasing ESG as a trend, investors should treat it as one lens among many. Evaluate funds not just on labels but on actual holdings, engagement strategies, and risk-adjusted performance. ESG isn’t a moral purity test—it’s a framework for identifying sustainable value. And while it may be facing a midlife crisis, that might just be the sign of a philosophy growing up.
