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.
Q1 hedge fund letters, conference, scoops etc
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. Economic theory (and common sense) 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 and should be expected to underperform.
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.
Read the full article here by Robert Huebscher, Advisor Perspectives
