Environmental, social and governance issues have become major themes in stock investing by exchange-traded funds. Now, other funds are bringing ESG approaches to bonds.

Investor appetite for ETFs focused on ESG-friendly bonds has surged this year. From the start of the year through Aug. 31, ETFs focused on ESG bonds recorded inflows of about $2.1 billion—about the same amount as for all of 2020, says Dave Nadig, chief investment officer and director of research at ETF Trends.  

ESG-themed...

Environmental, social and governance issues have become major themes in stock investing by exchange-traded funds. Now, other funds are bringing ESG approaches to bonds.

Investor appetite for ETFs focused on ESG-friendly bonds has surged this year. From the start of the year through Aug. 31, ETFs focused on ESG bonds recorded inflows of about $2.1 billion—about the same amount as for all of 2020, says Dave Nadig, chief investment officer and director of research at ETF Trends.  

ESG-themed funds invest in corporate or sovereign bonds. For example, iShares operates ESG Aware USD Corporate Bond   (SUSC), an $809 million fund that was down 0.38% this year through Aug. 31. Vanguard ESG US Corporate Bond fund (VCEB) has about $217 million in assets and was down 0.76%. A Vanguard spokesman says the provider expects growing interest in ESG products in the coming years, “as investors seek to avoid certain ESG risks and/or allocate capital to companies managing their ESG risks and opportunities effectively.” 

While corporate bonds can be screened using the same ESG criteria that are used to screen equities—for example, freezing out companies with links to fossil fuels or tobacco—it is more difficult to screen for favorable ESG qualities with sovereign bonds, Mr. Nadig says. That’s because nations are highly complex, potentially gaining ESG points in many areas while deriving significant wealth from petroleum, for instance. 

Investors might consider focusing not on a static view of a particular moment in time, but on whether the country or company is transitioning toward adopting more ESG-friendly policies, says Alexandra Wilson-Elizondo, deputy head of global credit at MacKay Shields. In June, MacKay Shields in partnership with IndexIQ launched IQ MacKay ESG Core Plus Bond (ESGB), an actively managed fund that integrates ESG factors into its selection process. 

Ms. Wilson-Elizondo says that when her fund weighs whether to invest in a particular country’s government bonds, the managers first consider broad standards of how that country treats its population, then looks at how it generates wealth. A certain level of oil distribution or consumption isn’t necessarily a red flag, she says, so long as there is a meaningful effort to transition to a more ESG-friendly future. Buying the country’s bonds can actually help fund those transitions, she says.  

“We’re very focused on changing the landscape going forward,” she says. “We don’t want to be constantly penalizing either corporate issuers or sovereigns.” 

While ESG investors tend to focus mostly on the environmental portion of ESG, the Covid-19 pandemic has also shone a spotlight on the social and governance pillars. This is a significant factor driving recent interest in ESG investments, including bonds, says Jordan Farris, head of ETF product at Nuveen, which operates   Nuveen ESG US Aggregate Bond (NUBD), a $264.6 million fund that was down about 1% this year through August, and Nuveen ESG High Yield Corporate Bond (NUHY), a $101.7 million fund that was up 2.1%.

With millions of workers transitioning to working from home, “people had a better appreciation for, as an example, companies’ approach to human capital development,” he says.  

Many ESG-focused bond funds haven’t had stellar returns so far this year. However, it has been a similar story for bonds in general, with the Bloomberg Barclays US Aggregate Bond Index, or the Agg—a commonly used benchmark for the U.S. bond market’s performance—down 0.69% through Aug. 31.  

Investors in ESG-themed bond funds “shouldn’t expect vastly different returns than conventional bonds,” says William Sokol, product manager for ETFs at VanEck, which offers VanEck Vectors Green Bond (GRNB), a $99 million ETF that was down 0.5% through August. GRNB offers exposure to green bonds, which are debt instruments issued for specific environmental purposes.  

ESG-focused bonds might outperform if environmental and other risks begin to be reflected in pricing, Mr. Sokol says. Regardless, investors should look upon such funds as a way of reducing ESG risks in their portfolio.  

“You’re likely getting similar returns,” says Mr. Sokol, “but you’re having a positive ESG impact.”  

Mr. Cowan is a writer in Northern Ireland. He can be reached at reports@wsj.com.