Are ESG Funds Compelling?

Are ESG Funds Compelling?

Most of the largest U.S. asset managers are signatories to the United Nations Principles of Responsible Investment (PRI). Signatories commit to “incorporate ESG issues into investment analysis and decision-making processes,” “be active owners and incorporate ESG issues into our ownership policies and practices,” and “seek appropriate disclosure on ESG issues by the entities in which we invest.” 

There is certainly evidence of movement on these key principles. The assets held by mutual funds or exchange-traded funds claiming a sustainability mandate has exploded past $1 trillion this year, more than double the amount of a year earlier. But this begs the question, what does a change in mandate or fund branding mean for investment portfolios? Does the mix of securities change? Do funds that incorporate ESG factors have materially lower risk exposure to issues like climate change?

I analyzed 110 U.S. large-cap mutual funds with an ESG mandate according to Morningstar’s database. Morningstar assigns each fund a portfolio ESG risk score — based on company ESG risk scores provided by Sustainalytics. The Sustainalytics company scores reflects exposure to, and management of, financially material issues across environmental, social, and corporate governance factors . 

The results of my analysis suggest 1) ESG-related risks are similar across funds — regardless of their labeling (e.g., ESG, sustainable, social), and 2) broad-market benchmark considerations still dominate the construction of ESG fund portfolios.

ESG Risk Scores Don’t Depend Much on Sustainability Mandates

The ESG risk scores of funds carrying a sustainability mandate are little different than those of funds without, at least by Morningstar’s measure. Notably, the portfolio ESG risk score of the Vanguard 500 Index Fund is better than that of more than 40% of the funds examined. The average ESG fund risk score of 23.8 (most companies have a score between 0 and 50) is virtually identical to the score of 24.1 for the Vanguard 500 Index Fund. ESG risk scores are clustered in a narrow range of 20.9 to 27.0. Even those large-cap funds with the lowest ESG risk aren’t markedly different than a fund tracking the S&P 500.

Note: Based on sample of 110 funds. Source: Morningstar.

However, ESG funds do tilt away from companies with controversies more than non-ESG funds. A prior analysis of a smaller sample showed more than 90% of ESG fund portfolios had lower controversy scores than a representative S&P 500 index fund. Controversies are incidents, such as a lawsuit or environmental accident, that may negatively impact a company or its stakeholders (including the environment). 

Taken together with the ESG risk scores, it appears ESG fund security selection is more heavily influenced by specific company events than quantitative measures. One reason for this could be the lack of consensus on how to measure and weight ESG issues. Data providers value ESG factors differently, and scores are often not comparable across industries — a recent analysis by State Street found a correlation of only 0.53 among the company scores of the four largest ESG data providers. Widespread adoption of company reporting standards (e.g., GRI, SASB) may help somewhat, but it won’t obviate the need for each manager to make value judgments about which ESG factors are most important.

Broad-market Benchmarks Loom Over Portfolio Construction

Benchmark considerations appear to constrain portfolio manager flexibility, limiting the impact of ESG factors on portfolios. The large-cap blend ESG funds examined all use a broad U.S. equity index as the fund’s benchmark — the S&P 500, Russell 1000 or Russell 3000. The growth and value ESG funds either utilize a broad U.S. equity index or its style variant (e.g., Russell 1000 Growth). Although all of the funds in our sample are actively managed, a desire to limit tracking error is apparent. For example, funds commonly hold a 2%+ interest in Google, Apple, and Microsoft.

And perhaps because of the size of the U.S. energy sector, the ‘E’ in ESG is usually assessed on a relative basis within industry groups. Fewer than 20% of funds exclude oil & gas companies. Additional funds also exclude coal mining — an easier stance to take as there are no large cap coal companies in the S&P 500. 

Most ESG funds limit stated business exclusions to industries that together comprise less than 5% of the S&P 500 universe. These tend to be industries like defense, alcoholic beverage and tobacco companies, and companies tied to nuclear energy. Such exclusions may attract values-based investors without significantly adding to the fund’s tracking risk.

New ESG Benchmarks May Be Next Step in ESG Fund Evolution

S&P Dow Jones introduced the S&P 500 ESG Index earlier this year. The methodology of the index aims to offer investors the S&P 500 excluding companies representing about 25% of the parent index with the lowest ESG scores in each industry. MSCI takes a similar approach with most of its ESG indices, aiming to provide a risk and return profile comparable to the underlying market while improving ESG measures. But to the extent company scores are clustered within industries, it is debatable whether the social and environmental impact of these indices will be superior to traditional indices like the S&P 500, Russell 1000, or MSCI AWI. 

Investors concerned with impact would be better off in funds that track the new Bloomberg SASB ESG indices or something similar. Bloomberg’s indices weight components based on composite ESG scores, and are more akin to equal-weight indices than the market-cap weighted indices that are the benchmark of most funds.

Divest or Engage? ESG Fund Investing Turns on This Question

Portfolio differences between ESG funds and non-ESG funds remain modest. Adoption of newer ESG benchmarks may increase differentiation over time, but pressure persists for index providers and funds to offer products that provide broad industry exposure. Ultimately, the decision to choose ESG funds or not may turn on the investor’s position regarding whether it is better to avoid companies with poor ESG track records or engage with them as owners in an effort to improve their environmental and social impacts. For investors firmly in the divestment camp, ESG funds may become increasingly compelling. But for investors who believe in engagement, ESG funds offer a more limited opportunity.

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