The performance of environmental, social and governance (ESG) funds has been unimpressive, according to new research, and the occasional outperformance is driven mainly by funds’ expenses, exposures to certain industries and factors. Advisors should adjust their due diligence to reflect those findings.
The popularity of ESG investing – it now accounts for more than $12 trillion (according to the Global Sustainable Investment Alliance), one out of every four dollars under professional management in the United States and one out of every two dollars in Europe – has been accompanied by heightened research into the subject, with more than 1,000 research reports published. Jan-Carl Plagge and Douglas Grim, of the research team at Vanguard, contribute to the literature with their study, “Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds,” which appeared in the February 2020 issue of The Journal of Portfolio Management.
Plagge and Grim investigated the performance characteristics of investable ESG equity funds to understand the key drivers of their performance. The dataset comprised both index and active equity mutual funds and exchange-traded funds with a U.S. investment focus that indicates the use of ESG factors in their investment process. They studied the 15-year period 2004 through 2018.
Their selection of ESG funds follows Morningstar’s sustainability rating strategies. They removed from their sample all funds with an industry-specific investment focus – they assumed the characteristics of these funds are mainly driven by industry-specific rather than ESG characteristics. As evidence of the increasing popularity of ESG investing, their empirical dataset began with a total of 98 funds and gradually increased over time to a total of 267 funds by the end of 2018. Of these 267 funds, 51 were index funds and 216 were active funds.
They distinguished between active, index, exclusion-based and non-exclusion-based funds. ESG funds that apply exclusionary screens typically avoid investing in companies that exhibit specific business involvements deemed to be negative, or in companies that do not meet a minimum standard of ESG behavior (such as tobacco, gaming, oil and gas, and nuclear energy). On the other hand, ESG funds without an exclusionary screen typically use an inclusionary (positive) screening method that overweights, or only includes, securities of companies that have exhibited strong aggregate performance on a set of ESG issues compared to their peers or a broader universe of companies. By the end of 2018, 119 funds applied at least one exclusion (and accounted for about 50% of assets), whereas 113 funds did not apply any specific exclusions. Following is a summary of their findings:
- After controlling for style factor exposures, the majority of funds in any of the tested ESG categories do not produce statistically significant positive or negative gross (before-fees) alpha.
- An industry-based performance contribution analysis revealed that while systematic differences in allocations relative to the broad market exist, their median contribution to performance is close to zero over time.
- Return and risk differences among ESG funds can be significant and appear to be mainly driven by fund-specific criteria rather than by a homogeneous ESG factor. For example, some funds have a large-cap focus, others a growth focus, and even one has a midcap focus. In addition, there are differences in industry concentrations (which lead to dispersion in returns).
- Across all four categories (index, active, exclusion-based and non-exclusion-based), the majority of observations display higher volatility than the broad market. This should not be a surprise because, by definition, ESG funds are less diversified than the market.
- The average expense ratio of active ESG funds is 1.1% per annum, more than twice as high as the average expense ratio of index ESG funds, at about 0.5% per annum.
- ESG funds with higher average expense ratios generally produce lower net alpha, an inverse relationship that holds true for both active and index ESG funds.
- Across all fund categories and all time periods (including three five-year subperiods), most gross alphas were negative in median terms, though not on a statistically significant basis.
- There was a modest decline in gross alphas over time for the categories of active funds and exclusion-based and non-exclusion-based funds – evidence of increasing market efficiency.
- A Fama-French five-factor (market beta, size, value, investment and profitability) analysis reveals negative loadings on the size factor (ESG companies tend to be larger). The other factor loadings tend to cluster around zero. The alphas also tend to cluster around zero. However, for active funds, the share with positive alphas declined over time.
Plagge and Grim concluded that due to the wide dispersion of outcomes caused by systematic differences in portfolio holdings, investors are best served by assessing investment implications on a fund-by-fund basis. They added: “Our mixed and dispersed performance results suggest that it is difficult to make generalizations on the investment risk and return impact when replacing a conventional US equity fund with an ESG fund. Carefully assessing the important and unique attributes of both funds seems to be an essential step in determining the potential direction and magnitude of any differences.”
If you are going to make ESG investing a core of your investment philosophy, thorough due diligence is required before committing assets. That due diligence should not only include the screening methodologies but also a careful examination of factor loadings, industry concentrations and expenses.
Larry Swedroe is the chief research officer for Buckingham Wealth Partners.
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The performance of environmental, social and governance (ESG) funds has been unimpressive, according to new research, and the occasional outperformance is driven mainly by funds’ expenses, exposures to certain industries and factors. Advisors should adjust their due diligence to reflect those findings.