On November 8, 2019, at 11:50pm, this article was corrected. The original version stated that, because ESG/SRI investors choose from a smaller universe of securities than an unconstrained manager, they should expect to underperform a risk-adjusted benchmark. That is not correct. Reducing the size of the investable universe does not reduce the expected returns. The article was edited to correct that error. For more information on that correction, see the comments in APViewpoint.
We’d all like our investments to make a positive contribution to environmental, social and governance (ESG) issues. But, as predicted by economic theory, ESG funds have suffered a performance deficit over a long time horizon.
The question of whether ESG funds have outperformed an appropriate benchmark on a risk-adjusted basis has been studied extensively (see here for a survey of that research). But I was intrigued by a recent study by Wayne Winegarden, an economist and senior fellow with the Pacific Research Institute (PRI). Winegarden looked at 30 ESG funds, 18 of which have a 10-year track record and the remaining 12 of which outperformed the S&P 500 over the recent past.
Only 1 of the 18 outperformed the S&P 500 over a five-year investment horizon, and only 2 beat the S&P 500 over a 10-year horizon. The results were no more encouraging for the 12 recent outperformers.
What is responsible for this underperformance? Let’s look at the sobering data on ESG performance, and then the explanations for it.
The sad reality
Let’s say you have two equally competent portfolio managers, one of whom can select investments from an unconstrained universe, but the other is restricted to a subset of that universe. Our intuition says that the former will outperform the latter. As Winegarden said to me when I interviewed him over the phone, “Options have value. Anytime you restrict your options, you're going to be harming your potential performance.”
ESG investors choose from a subset of available securities. But contrary to our intuition, that should not lead to underperformance. It could lead to increased risk, as measured by standard deviation, but only if the size of the universe was reduced to about 30 securities.
Winegarden did his research using data from Yahoo Finance. I wanted more complete data. I also wanted to confirm that Winegarden’s results weren’t affected by an ideological bias. PRI is a California-based “think tank” that advocates for free market principles and individual freedom. For example, it has advocated against universal health care.
I asked our research staff to confirm his findings using data from Morningstar. Morningstar provided us with data for the 148 U.S. equity mutual funds with a 10-year record within three categories (ESG integration, impact and sustainable sector). Omitted were those funds that have added ESG to their consideration among other factors more recently.
Here’s what that data revealed:
- The average annual return of ESG funds was 8.19%, versus 13.95% for the S&P 500. That is an underperformance of 576 basis points annually.
- Only 10 of the 148 funds (7%) outperformed the S&P 500.
- The average annual Morningstar risk-adjusted performance was 6.49%.
- The ESG funds had an average annual standard deviation of 12.81, versus 12.59 for the S&P 500, so they were slightly more volatile than the S&P 500.
- The average expense ratio for the ESG funds was 0.97%, versus approximately 0.06% for an S&P 500 index fund.
In any analysis of fund performance, expenses will explain a good deal of performance. We looked at whether investors could achieve better results by selecting only the lowest-cost funds:
- The average annual return of the 15 funds in the lowest decile of expense ratios was 9.66%, underperforming the S&P 500 by 429 basis points. That cutoff was an expense ratio of 50 basis points.
- The average annual return of the 15 funds in the highest decile of expense ratios was 6.50%, underperforming the S&P 500 by 745 basis points. That cutoff was an expense ratio of 1.48%.
- The average annual return of the 5% of funds (8 funds) with the lowest expense ratios was 11.85%, still underperforming the S&P 500 by 210 basis points.
Neither our analysis nor Winegarden’s takes into account “survivorship” bias. We looked at only the 148 funds that survived the entire 10-year period, and did not account for those funds that were closed, merged, or ceased to be ESG funds over that period. When a fund closes or is merged, it is typically because of poor performance. This survivorship bias means that the above results likely understate the degree of underperformance of ESG funds.
Our analysis and Winegarden’s is compromised because of the use of the S&P 500 as the common benchmark for comparison. This is a large-cap index and it may be inappropriate for some of the funds in our sample.
Our results and Winegarden’s confirm that investors have sacrificed performance when they invest in an ESG fund. The most likely explanation is the higher fees charged by many of the funds.
More recent data is encouraging
Morningstar has studied the issue of ESG performance at length and has some more encouraging results – particularly over recent timeframes.
A representative at Morningstar provided me with the following information on two studies it has done:
The first study looked at Morningstar’s 56 unique ESG-screened indexes found that 73% (41 of 56) outperformed their non-ESG equivalents since inception.
A second study, the U.S. Sustainable Funds Landscape report, found that sustainable funds, on average, outperformed on a relative basis in 2018: 63% of sustainable funds finished in the top half of their respective categories, including 35% in the top quartile. Only 37% finished in the bottom half, including just 18% in the bottom quartile. For equity funds alone, the percentages were about the same, and there were no significant differences between ESG consideration, ESG integration, and impact funds.
On average, over the past four years, sustainable funds have held their own in up markets and outperformed in down markets relative to their conventional peers. The worst relative showing for sustainable funds over that period, although still above average, was 2017 when the S&P 500 was up 21.8%. The best relative showing prior to 2018 was in 2015 when the S&P 500 barely managed a positive return.
While sustainable funds pursue a range of investment strategies, a common element among most – particularly diversified equity funds – is the consideration of ESG criteria in their investment process. This generally leads to a preference for companies that are managing material environmental and social issues effectively and have strong corporate-governance practices. These tend to be lower-volatility, higher-quality companies that hold up better in difficult market conditions. (See here for more information.)
My concern with Morningstar’s findings is that it focused on a recent, short time horizon, rather than the 10-year period that Winegarden and our staff researched. Also, its statement that ESG-friendly companies have lower volatility is inconsistent with the 10-year data presented above.
Larry Swedroe’s research has also shown the performance deficit of ESG investing over a long time frame. He looked at the MSCI ESG index data since 2010, and found that the ESG indices provided lower returns, and lower risk-adjusted returns, than the broad market index.
Why have ESG funds fared so poorly?
High costs offer the overriding insight into why ESG funds have fared poorly, but there are other factors to consider.
Winegarden cited one factor that I hadn’t heard before. Two companies, ISS and Glass Lewis, control approximately 97% of the proxy votes in the U.S. Those firms are biased towards supporting ESG proxy statements, according to Winegarden, as evidenced by the existence of their own ESG advisory services. Winegarden said that many of those ESG ballot issues “are neither desired by customers nor employees. As a consequence, these programs are linked to financial under-performance and warrant caution.”
As an example, Winegarden pointed to testimony by a candidate for the board of California’s pension system (CalPERS), who said that its divestiture of tobacco companies had cost the system $8 billion. In fairness, this was not an example of a measure advocated by a proxy firm nor did it affect an ESG fund. But tobacco divestiture is typical of the exclusions employed by ESG funds, and the outsized influence of the duopoly of proxy firms is a valid issue that deserves further study.
Nonetheless, companies that pursue appropriate ESG policies, are responsible stewards of the environment and serve the best interests of their employees and the community should be candidates for investment. They may be more profitable or have a higher return-on-equity than the average company. However, this does not mean that the stocks of those companies will outperform. The individual characteristics and performance of a company are already reflected in its stock price. The market is sufficiently efficient to ensure that, especially given the approximately $12 trillion dollars (as of 2018) invested with an ESG mandate. Those asset flows have surely driven up the prices of companies with good policies on sustainability, and offer an explanation for Morningstar's findings of strong, more recent ESG performance.
Don’t be misled by academic studies that show that good ESG policies at the corporate level are correlated with high company profitability or similar metrics. That says nothing about expected future stock performance or the performance of ESG funds.
What should investors do?
When it comes to ESG, to pursue an investment strategy that is consistent with your personal values, choose a low-cost fund. Recognize, however, that there is an overwhelming likelihood that you will sacrifice performance, on a risk-adjusted basis, relative to an index fund – and that sacrifice could be substantial and costly.
Investors should ask whether the ESG mandate that governs a fund’s security inclusion and exclusion rules is aligned with their own beliefs. An investor might be happy, for example, that a fund excludes fossil fuels. But it may also exclude nuclear energy, which almost all scientists agree must be part of the solution to the threats posed by climate change.
ESG fund construction is an inexact science. Companies that pursue laudable research in areas such as water purification or recycling may also have a legacy business that does defense contracting. As an ESG investor, you want to support the research that aligns with your values, but do you want that company to be forced to divest what might be a profitable legacy business at an unattractive price?
Given these concerns, there is one strategy which ensures that investors provide financial support for the ESG-related issues that matter the most to them: Buy a low-cost, passive fund, calculate the performance gain you achieve over an ESG fund, and donate that amount to charities that are aligned with your personal values.
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