Environmental, social and governance (ESG) investors face outsize fund-specific selection risks with a wide dispersion of returns between similar strategies, according to a new Scientific Beta report.
The study found a 6.5 per cent gap (or almost 5 per cent after allowing for industry tilts) between the best- and worst-performing strategy among a cohort of sustainable- or ESG-themed passive US equities exchange-traded funds (ETFs) over the six years to the end of 2022.
“Over single years, the dispersion can be even more dramatic, reaching a maximum of 22.5% in terms of returns adjusted for market exposures, and 25.3% in terms of industry-adjusted returns,” the Scientific Beta report titled ‘From ESG Confusion to Return Dispersion: Fund Selection Risk is a Material Issue for ESG Investors’ says.
And the study suggests traditional gauges used to screen funds for risk such as “past performance or tracking error” don’t translate to the ESG product universe.
Felix Goltz, Scientific Beta research director, said in a statement: “Our evidence emphasises that inconsistencies in ESG approaches contribute to significant dispersion in the performance of ESG investment products. Investors need to be aware that fund selection risk is a material issue for sustainable investment strategies.”
Goltz said the wide disparity in sustainable fund returns is also a boon to marketers who can always point to some ESG strategy outperformance over the short-term.
“The evidence from the literature on funds’ flows suggests that investors are particularly sensitive to recent performance,” he said.
“This issue is aggravated by the fact that there is no consensus on the definition of ESG, which gives ETF providers a license to come up with new products that replicate ESG approaches that have recently outperformed. It remains to be seen whether the industry will move towards harmonisation of ESG definitions and practices, a shift that would reduce divergence and ultimately returns dispersion.”
The paper follows on from a 2021 Scientific Beta study that found that ESG doesn’t deliver alpha or downside protection while the quality factor alone accounted for three-quarters of performance attributes of funds in the sector.
“It might be time to consider ESG strategies for the unique benefits that they can provide, such as hedging climate or litigation risk, aligning investments with norms, and making a positive impact for society,” the 2021 report notes.
Scientific Beta is a research and factor-based index firm owned by the Singapore stock exchange.