Our analysis of popular ESG funds provides a toolkit to detect greenwashing and separate the most authentic green investments from the rest.
As a wave of money rushes towards green funds, investors may wish to cast a critical eye on fund ‘greenwashing’ which embellishes an investment’s ethical credentials even though it barely provides any ESG advantage compared to its benchmark.In the U.S., ESG fund assets under management reached $330 billion in September 2021, up from $236 billion at the end of 2020, according to Morningstar Direct, leaving investors vulnerable to buying products which don’t do what they say on the tin.
Figure 2 broadens the set of funds in the analysis and shows the current ESG advantage of eight U.S. ESG equity funds with assets ranging from about $1billion to $30 billion. The bars in the chart indicate the difference between a fund’s ESG rating and its benchmark’s ESG rating. The eight U.S. ESG equity funds are benchmarked to the S&P 500 Index, the MSCI USA Index, or the Russell 1000 Growth Index, according to fund prospectus information. The chart shows that the 3 largest funds by assets offer the least ESG advantage, beating only about 3-4% more companies in ESG quality than their corresponding benchmarks. The tier of funds in the middle of the chart, boxed in gray, offer more than double the ESG advantage of the tier of funds on the right. But that’s still only about half the advantage of our ESG Overlay portfolios, shown on the left.
Even if a fund achieves a decent ESG advantage, there’s another important factor to consider – the risk taken by the fund. Any fund that claims better ESG credentials than its benchmark must deviate from that benchmark to achieve that. To visualize how much benchmark-relative risk the fund takes to achieve its ESG advantage, the scatter plot in Figure 3 shows the ESG advantage (vertical axis) and the active share (horizontal axis) of the funds/portfolios above. A fund’s active share measures the fraction of the fund’s holdings that deviate from its benchmark index.The S&P 500 and MSCI USA benchmarks are at the lower left corner, as they have zero ESG advantage and zero active share. The purple dashed line shows a linear-fitted line between ESG advantage and active share for most of the funds (excluding outliers), represented by the blue dots. Outliers are the red dots on the lower right, representing Funds H and I, and the green dots on the upper left, showing our ESG Overlay portfolios on the S&P 500 Index and MSCI USA Index.
The ESG Overlay portfolios (green dots in Figure 3) provide superior ESG qualities with modest benchmark-relative risk, but do they sacrifice returns to achieve this? The top panel of Figure 4 plots the ESG advantage of the eight U.S. ESG equity funds we analyzed and our two ESG Overlay portfolios. The bottom panel of Figure 4 shows their 3-year and nearly-7-year annualized excess returns, highlighting that the ESG Overlay portfolios do provide alpha. The ESG Overlay for the S&P 500 has provided 2.3% annualized excess return over the past three years, while the MSCI version provided 1.8%. The annualized excess returns for these two ESG Overlay strategies since January 2015 was about 1.1%. Interestingly, excess returns for all the ESG funds featured in Figure 4 improved over the past three years. The results don’t indicate that ESG funds generally outperformed their benchmarks over a longer period (since 2015). But the ESG Overlay approach did outperform, while providing superior ESG advantage.
There’s a huge variability in ESG quality among ESG funds with some taking substantial benchmark-relative risk to achieve a minimal ESG advantage. These funds deviate considerably from their benchmark, yet they are “benchmarkhugging” in terms of ESG advantage.
Earlier this year, we introduced an ESG Overlay technique that re-weights each company relative to industry group peers in the S&P 500 Index according to its consensus ESG rating. Here, we’ve shown that this strategy achieves excellent ESG advantage with modest benchmark-relative risk – a notably better ESG profile than the alternatives analyzed here. Moreover, the ESG benefit comes with a 2.3% annualized excess return over the S&P 500 benchmark for the past three years, showing that you can do well while ‘doing good’
The metrics we’ve introduced and applied to the sample of eight ESG funds considered here show reason for caution. The ESG label on the tin doesn’t tell you enough about the ESG quality of the ingredients inside.
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Head of Equities Quantitative Strategy
Quantitative Investment Strategist
Quantitative Investment Strategist
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