An ESG mandate fulfills the noble goal of aligning investors’ portfolios with their personal values and beliefs. But new research affirms what financial theory predicts: Those investors will incur a penalty in terms of risk-adjusted performance.
Q3 2019 hedge fund letters, conferences and more
Over the past decade, there has been a dramatic increase in ESG (environmental, social, governance) investing strategies. In their “2018 Report on U.S. Sustainable, Responsible and Impact Investing Trends,” the US SIF Foundation found that assets denoted as socially responsible products “grew from $8.7 trillion at the start of 2016 to $12.0 trillion at the start of 2018, a 38% increase. This represents 26% of the total U.S. assets under professional management.
ESG strategies allow investors to express their social views through their investments. This helps explain why a recent survey by FTSE Russell showed that of the nearly half (46%) of global asset owners that have an allocation to smart beta, 41% of those using it anticipate applying ESG considerations.
While providing the benefit of being able to express their social views, investors should also be concerned about how these strategies perform. Wayne Winegarden, of the Pacific Research Institute, contributes to the literature with his May 2019 study “Environmental, Social, and Governance (ESG) Investing: An Evaluation of the Evidence.” He evaluated the performance of 30 ESG funds that had either existed for more than 10 years or had outperformed the S&P 500 Index over a short-term timeframe. The following is a summary of his findings:
- Of the 18 ESG funds examined that had a full 10-year track record, a $10,000 ESG portfolio (equally divided across the funds, including the impact from management fees) would be 43.9% smaller after 10 years compared to a $10,000 investment into an S&P 500 Index fund.
- Only one of the 18 funds exceeded the return of an S&P 500 benchmark investment over a five-year investment horizon, and only two were able to beat the S&P 500 benchmark over a 10-year investment horizon.
- ESG funds were more expensive, with an average expense ratio of 0.69% versus the much lower (single-digit) expense of an S&P 500 Index fund. The average expense ratio of the subcategory of ESG funds that focused on social goals was an even higher 0.89%. Over long investment horizons, these much higher expenses create a significant drag on returns, assuming returns are similar otherwise.
- ESG funds were also riskier as measured by concentration. On average, their top 10 holdings constituted 37% of the portfolio compared to 21% for a broad-based S&P 500 Index fund, significantly reducing diversification benefits. In one fund, the VanEck Vectors Environmental Services ETF (EVX), the top 10 holdings represented 64% of the portfolio – I found that as of May 28, 2019, the top four holdings comprised 43% of the portfolio. Concentration at these levels imposes large risks on investors.
Winegarden concluded: “Judged against past performance, ESG funds have not yet shown the ability to match the returns from simply investing in a broad-based index fund. Explicitly recognizing this tradeoff is essential to enable investors to better pursue their financial goals in the manner that reflects their values and the costs they are willing to bear.”
Read the full article here by Larry Swedroe, Advisor Perspectives
