Are ESG Funds Really a Good Long-Term Investment?

This post was originally published on this site

Environmental, social, and governance (ESG) investing is growing at an unprecedented rate. Recent financial results seem to indicate that ESG funds have “a clear performance advantage” relative to their non-ESG counterparts, which is encouraging advocates to claim that ESG funds offer investors a win-win opportunity to do well while doing good.

Despite some positive short-term results, there are many reasons for caution. Before reviewing these, it is important to note that many investors may demand investment options that reflect their values, regardless of whether these funds outperform. ESG funds cater to this demand.

However, even when individual investors are prepared to select an ESG investment option regardless of increased risks or potential underperformance, they deserve accurate information regarding the risk-return profile of their portfolio. Given the complexity of the ESG investment universe, the current statements about ESG outperformance may not be meeting this criterion.

Let’s start with the problems that arise due to the vagaries of ESG criteria. There is no single definition of an ESG-compliant investment. One organization’s ESG star could be another’s laggard. How do you rate a company that pays a minimum wage of $15 an hour, a typical goal of ESG proponents, but also emits large amounts of CO2, which violates a different goal?

An ESG fund that emphasizes “social” (the S in ESG) could rate such a company highly, whereas an ESG fund that emphasizes the impact from a company’s operations on the environment (the E in ESG) could rate the company poorly. As a result, firms and organizations that rate companies based on their commitment to ESG are making judgments that are not only inherently subjective, but may also often contradict one another.

There are some significant material differences between ESG strategies. Some ESG funds apply an exclusionary investment criterion that simply avoids companies engaged in specific business lines (e.g., fossil-fuel companies). Others will explicitly invest in companies that are meeting predefined ESG criteria (e.g., funds that specialize in investing in alternative-energy technologies). It makes little sense to compare the financial performance of a broad-based fund that simply excludes specific sectors (e.g., gun manufacturers and gambling firms) and is heavily reliant on the FAANG stocks [Facebook, Amazon, Apple, Netflix, and Google (Alphabet)] with a fund that exclusively invests in alternative-energy technologies.

Blanket statements about the financial performance of ESG funds as a whole fail to account for these vastly different ESG investment strategies. Consequently, making broad pronouncements about the outperformance of ESG funds will provide little information about the financial performance of specific ESG investment strategies.

There are also important long-term considerations. It is not surprising that, over the past several years, a manager for a broad-based ESG fund would have been able to abstain from investing in fossil-fuel firms and still build an investment portfolio that financially outperforms the market. After all, the FAANG stocks “averaged a 58.0 percent total return (price plus dividends) in 2020, compared to an 18.4 percent return for the S&P 500.” It is hard to argue that the FAANGs, which tend to score well against ESG benchmarks (not least because of their relatively low environmental impact) owe that return to their ESG scores: The investors who buy these shares tend to have other things in mind.

This recent outperformance does not provide any information regarding how ESG funds will perform over the long term. In fact, the long-term performance does not match these short-term results. For example, a 2017 study in a top finance journal examined 2,000 funds engaging in social investing. Unlike past studies that bluntly classified funds as either socially responsible or conventional, the authors created a methodology to capture the varying degrees of social responsibility of these funds. Summarizing the results of this study, Kenneth Kim of EQIS Capital Management noted that the results conclusively showed that “when investing in SRI [socially responsible investing] or CSR [corporate social responsibility] funds, one should expect some underperformance.”

ESG funds also contain unidentified risks that often go undiscussed. In a study I performed, ESG funds allocated 37 percent of their portfolio toward their top 10 holdings on average, compared with 21 percent for a broad-based S&P 500 index fund. The higher exposure to the top ten holdings means that the returns of ESG funds are more dependent on the performance of relatively fewer stocks. This concentration significantly reduces the benefits that ought to flow from diversification.

For instance, broad-based ESG funds that shun fossil-fuel companies but have greater exposure to the FAANG stocks would have performed very well in 2020. In this case, shunning fossil-fuel investments improved financial returns. While excluding certain investments may have enhanced past results, these trends change. The caveat “past performance is not indicative of future results” is apropos.

As of April 14, ExxonMobil is up around 39 percent year to date, whereas Apple is up a bit over 3 percent. Perhaps these trends indicate that shunning fossil-fuel investments will harm relative returns for ESG funds for all of 2021. Perhaps not. What this example definitively demonstrates, however, is that ESG funds are assuming specific investment risks, risks that may well not be clearly expressed to those looking to purchase them.

Another problem that has arisen is whether ESG funds are actually executing what most investors assume will be their stated strategy. For instance, a 2019 Wall Street Journal article found that the portfolios of several ESG funds held a larger share of bonds issued by Saudi Arabia than did non-ESG funds.

Not only does Saudi Arabia have large oil interests, which are typically eschewed by ESG investors, but the kingdom has a dismal human-rights record. It’s hard to see how these features can be reconciled with the expectations of most ESG investors. To be fair, there were specific reasons why these funds ended up being overweight Saudi Arabia, many related to the lack of ESG-related opportunities in emerging markets, but, for all that, this case is a reminder that the reality of ESG may differ from the labeling.

This example also raises concerns with respect to the measurement of ESG funds’ financial performance. If ESG funds pursue a strategy that is difficult to reconcile with what most people would understand as living up to ESG, claims that ESG funds outperform non-ESG investment strategies need to be treated with more skepticism. Do the studies that compare the relative performance of ESG funds exclude those funds that are failing to effectively execute an ESG strategy as that term would be commonly understood? And how do you measure whether an ESG fund is effectively executing its strategy? Without reliable answers to these questions, which have not been forthcoming, the actual impact from effective ESG criteria on investment returns is still unknown.

The problem of faithfully executing an ESG strategy also raises the question of cost. Executing an ESG strategy adds another layer of administration, which is why ESG funds tend to have higher administrative costs relative to non-ESG funds. Since there is a problem of whether ESG funds are executing their strategies in a manner that their investors might reasonably expect, perhaps these already inflated costs are still insufficient. Basic finance theory consistently advises investors to avoid vehicles with large administrative costs due to the negative impact of costs on investment returns.

A final concern not adequately addressed by advocates of ESG is its suitability to large public and private pensions. Pension funds have a fiduciary responsibility to workers and retirees, a diverse group of investors who cannot exit the relationship and may hold differing views about complex social issues. Public pension funds also have a responsibility to taxpayers who will ultimately bear the costs from any investment underperformance. Given the unclear long-term investment performance of ESG funds and the diversity of opinions on social issues, pension investment decisions should only be guided by the funds’ prime directive: to meet its financial obligations to current and future retirees.

In recent years, ESG funds have been presented to investors as socially responsible investments that outperform their respective benchmarks. While this may be true for some funds in the short term, the long-term record suggests that investors risk higher costs, greater volatility, and lower returns from investing in ESG funds. These experiences warrant caution in the face of today’s growing exuberance.

More from National Review