For fund managers, the period ahead "could be like a baptism of fire," Mr. Penny said.
There are now signs that interest in ESG investments is flagging. After more than three years of inflows, stock investors pulled about $2 billion from U.S. exchange-traded ESG funds in May, the biggest monthly redemption on record, according to Bloomberg Intelligence.
Meanwhile, the Impact Shares MSCI Global Climate Select ETF is set to close after less than a year because none of the backers pitched in with anticipated funding.
The tougher market environment for ESG has coincided with growing disillusionment. Insiders such as activist hedge fund boss Chris Hohn have publicly lambasted the way in which much of the asset management industry does ESG, characterizing it as toothless.
And according to a recent survey conducted by the Journal of Financial Planning and the Financial Planning Association, there are signs of a broader cooling under way in sentiment toward ESG. The investment model "may have reached an inflection point," the groups wrote in a news release.
"It's the environment that's causing ESG stocks to underperform, but it's also sentiment causing ESG stocks to underperform," Mr. Penny said. He added that ESG fund managers need to be more selective and come up with "a full suite of different investment strategies" rather than rely on a limited number of asset classes.
TAM Asset Management has been working on diversifying. The goal is to find ethically sound investments that are uncorrelated, which could include dividend paying stocks, property, infrastructure or funds with an overweight to health care, he said.
TAM is tilted towards quality and value, but still has exposure to growth stocks in its ESG strategies, Mr. Penny said. Ultimately, the goal for investors right now is not to lose money, he added.
"You've got this broad-based sentiment turning against even high-quality companies," he said. "People are just very fearful."
