Investors searching for alpha—to beat the market—won’t find it in socially responsible investing. A new study examining a decade of data finds portfolios of exchange-traded funds (ETFs) that follow environmental, social, and governance (ESG) investing strategies did not perform any better than standard index funds.
The study by Scientific Beta, an index provider and consultancy linked to France’s EDHEC Business School, found that ESG ETF funds underperformed by an average of 0.2% on an annual basis when compared to a proxy for the US equity market.
Only one year, 2020, stood out with ESG ETFs outperforming by 4.2%. That was primarily due to the funds’ exposure to red-hot technology stocks, which alone contributed to more than half the overperformance versus the broad benchmark index.
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But one good year doesn’t make a trend. The study concluded that on an annual basis, both average relative returns and capital asset pricing model alpha, a measure of excess returns over a benchmark, are close to zero over the past decade.
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What is a socially conscious investor to do?
Giovanni Bruno, a co-author of the Scientific Beta study and the group’s senior quantitative researcher, says the findings don’t suggest that socially conscious investors should shy away from investing in this space.
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“ESG neither substantially boosts nor hampers performance,” he said. “So conscious investors can still make money investing in portfolios that allow them to extract systematic factor risk premium such as the market, value, size, momentum, and quality.”
Miguel Padro, an assistant director at the Aspen Institute think tank, agrees but adds a caveat: beware of big promises of outperformance.
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The ESG label conundrum
Part of the contention over ESG investing is the ESG label itself.
“ESG is just an abbreviation for categories of potentially investor-relevant information that don’t show up on a company’s balance sheet. ESG is not an asset class,” Padro said.
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The US Securities Exchange Commision dealt with the rise of ESG fund labeling in 2021 by ramping up scrutiny of investment companies, to ensure there are quality checks, policies, and protocols in picking companies for ESG portfolios.
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In 2022, the SEC charged BNY Mellon Investment Adviserfor misstatements and omissions due to a number of investments held in ESG-designated funds without any review of whether they deservedto be labeled as such.
“Why would we assume [ESG] stocks should outperform?”
Judy Samuelson, who runs the Business and Society Program at Aspen Institute, says investors in ESG-themed funds should stay focused on the long view, and on what component companies are doing to serve their environmental, social, and governance standards.
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“Why would we assume the stocks should outperform?” shesaid. Companies that“do good” aren’t necessarily cheaper to run, she warns.
“Mostso-called ESG funds that run in public markets are not structured around stocks that are likely to be better performers, but rather about climate, or treating their employee better, toxic practices, human rights abuses, and so on,” said Samuelson.
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To that end, she said,“we need fresh thinking” on boards. “The investors care, their employees care… Many people are keen to invest in companies that care. They want a planet, they want their grandchildren to grow up to have a quality life.”
Critics of ESG — such as a group of Republican states that banned Blackrock and other “ESG friendly” asset managers from their state pension plans — argue that considering environmental and social factors violates the fiduciary duty that asset managers have towards their clients.
The research showed that overall, sustainable funds have consistently shown a lower downside risk than traditional funds. And while some ESG funds are relatively new (particularly many passive ones), they've been able to show solid performance and resiliency in both good markets and bad.
Globally, ESG Leaders earned an average annual return of 12.9%, compared to an average 8.6% annual return earned by Laggard companies. This represents an approximately 50% premium in terms of relative performance by top-rated ESG companies.
Another objection to investing on ESG principles is that because so many investors are attracted to companies with high ESG scores, the prices for such securities are inflated. Thanks to their popularity, their past performances have been strong, but their future returns will be weaker. Pay more, get less.
The result was that in reality these cars were emitting nitrogen oxide pollutants up to 40 times above the limit in the US. The company later admitted to cheating on emissions tests, stating that 11 million cars were fitted with this device worldwide.
For some proponents, anti-ESG investing is about maximizing profits without regard to a company's governance factors or its impact on society and the planet. These investors often argue that a company should be evaluated solely on the basis of financial performance.
However, there are also some cons to ESG investing. First, ESG funds may carry higher-than-average expense ratios. This is because ESG investing requires more research and due diligence, which can be costly. Second, ESG investing can be subjective.
BlackRock ranked as the biggest ESG asset manager, accounting for 20 of the top 100 such funds, with total assets under management of $110 billion. DWS Group came in second place with $36 billion in AUM (comprising 11 funds), followed by Parnassus Investments with $33 billion (three funds).
While ESG funds recovered in 2023, they mostly underperformed market benchmarks. For example in Europe, which has the biggest market, ESG-related funds rose about 16% on average, compared with the 24% gain of the MSCI World Index and the 16% return of the STOXX Europe 600 Price Index.
ESG Fund Returns Recover, but Still Trail Conventional Peers by a Small Margin. The tech stocks that helped ESG funds and the utilities that hurt them in 2023. Sustainable funds performed much better in 2023 compared with 2022, but results were mixed across asset classes.
However, this environmental, social, and corporate governance transformation is not without its challenges: 85% of asset managers acknowledge ESG investing as a high priority for their companies. 64% express concerns about a lack of transparency and corporate disclosure regarding ESG activities.
Global investors pulled £8billion from woke ESG funds last year amid a backlash over greenwashing and the 'vague' promises they offer. Figures from industry group Calastone show the three-year boom in the funds focused on environmental, social and governance issues was now over.
BlackRock's decision to shift from ESG investing to transition investing marks a significant evolution in the sustainable investing landscape. This strategic move underscores the importance of actively supporting transitioning companies to drive accelerated change.
Buyers of these products can be fickle and jump to the next theme—often too quickly for their own good, a Morningstar analysis showed last November. It is possible that the overly generic ESG brand will never recover its appeal, with the different parts of it eventually rebranded to suit their specific client bases.
The core argument against ESG is that something that's good for the environment and for people can't be good for business. Opponents have moved beyond rhetoric to action. More than two-thirds of states proposed anti-ESG legislation in 2023, half of which passed.
However, there are also some cons to ESG investing. First, ESG funds may carry higher-than-average expense ratios. This is because ESG investing requires more research and due diligence, which can be costly. Second, ESG investing can be subjective.
One of the biggest concerns related to ESG investing is inconsistency across ESG indexes and ratings, which makes it difficult for fund managers, investors, and consumers to draw reliable insights and comparisons across firms.
Examples of ESG scandals. Johnson and Johnson failed to disclose Neutrogena and Aveeno sunscreens contain the carcinogen benzene, a cancer-causing chemical (Downs et al., 2021). Johnson and Johnson announced a voluntary recall of selected Neutrogena and Aveeno aerosol spray sunscreens on July 14.
Introduction: My name is Greg O'Connell, I am a delightful, colorful, talented, kind, lively, modern, tender person who loves writing and wants to share my knowledge and understanding with you.
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