ESG, alpha, and 401(k)s

November 11, 2020

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Investment strategies with an environmental, social, and governance (ESG) dimension are growing in popularity. According to the Global Sustainable Investment Alliance, the global assets held in ESG-screened investments more than doubled between 2012 and 2018, to $26.3 trillion from $12.3 trillion.

As interest in ESG investing increases, both individual and institutional investors may wonder about the impact a shift to such investments would have on their return expectations. A research paper published by Vanguard Investment Strategy Group's Jan-Carl Plagge and Doug Grim in The Journal of Portfolio Management examines whether ESG equity fund strategies come with a cost in the form of lower expected returns, higher volatility, or both.

The paper—Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds—may hold particular value for institutional investors, as the Department of Labor (DOL) earlier this year proposed a rule that would have made it more difficult to include ESG strategies in 401(k) plans. The DOL issued a final rule on October 30 that no longer specifically references ESG investments in the final text of the rule, but would prohibit these and other strategies in 401(k) plans if they take on additional risk or promote goals unrelated to the financial interests of their participants. (We submitted a comment letter to the proposed rule on July 30, 2020, expressing our view that ESG investments can play a role in helping retirement savers achieve investment success and should not be subject to increased regulation.)

ESG fund performance varies

Mr. Plagge and Mr. Grim looked at ESG mutual funds and ETFs focused on U.S.-listed stocks and investigated differences in their gross returns and volatility (standard deviation of returns) over a 15-year period compared with the FTSE USA All Cap Index. They distinguished between index and active funds and between funds that apply explicit exclusions and those that do not. Dividing the sample period into three five-year periods, they found a high level of dispersion for both risk and return among ESG strategies. (See chart below.)

"We found funds with higher returns and higher risk, lower returns and lower risk, higher returns and lower risk, and lower returns and higher risk than their investment universe," Mr. Grim said. "Overall, our findings suggest that ESG funds have neither systematically higher nor systematically lower raw returns or risk than the broader market."

ESG funds produce mixed risk and return results versus the broad market

ESG funds produce mixed risk and return results versus the broad market
Notes: The data points reflect the annualized five-year standard deviation and gross return of each fund minus the broad U.S. equity market as proxied by the FTSE USA All Cap Index. ESG fund categories include index funds, active funds, exclusion based, and nonexclusion based. The figures include data of three five-year periods: January 2004 to December 2008, January 2009 to December 2013, and January 2014 to December 2018. The numerical values in each quadrant represent the share (%) and number (x) of ESG funds—time period combinations in each category that fall into the respective quadrant. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment because one cannot invest directly in an index.
Source: Authors' calculation based on data from Morningstar, Inc.
© 2020 Pageant Media. Republished with permission of PMR Journal of Portfolio Management. Have investors paid a performance price? Examining the behavior of ESG equity funds, Vol 46, Issue 3 Ethical Investing 2020. For more information, please visit www.PM-Research.com. All rights reserved.

Do ESG funds deliver alpha?

The authors then tried to identify potential alpha across these strategies. To control for factor tilts, they evaluated the performance of ESG strategies against that of each of the factors in the Fama-French five factor model: market, size, valuation (value/growth), profitability (quality), and capital investment.

The market factor proved, as one would expect, highly significant across the entire fund universe. The influence of style factors, on the other hand, was much less consistent. Some ESG funds had statistically significant and positive exposures to a given factor, while others had a significant but negative exposure to the same factor—and some had no noteworthy exposure to that factor at all.

Many of the funds performed quite differently compared with the market-capitalization-weighted U.S. equity market. "However, after controlling for the impact of known sources of risk—that is, market- and style-factor exposures—the majority of ESG funds did not produce statistically significant positive or negative gross alpha," Mr. Plagge said. "Return and risk differences of ESG funds can be significant, but they appear to be mainly driven by fund-specific criteria rather than a homogeneous ESG factor."

Because ESG funds often favor new technologies and avoid certain sectors, such as those relating to fossil fuels, the researchers were interested in the effects of such systematic deviations in industry exposures. Funds in the sample tended to be slightly underweighted in finance, energy, minerals, and consumer services and slightly overweighted in health and technology. However, the authors found the effects of these deviations on relative fund performance to be very small in median terms when sampled on a quarterly basis across the 15-year period with all funds observed.

Mr. Grim and Mr. Plagge then calculated net (after cost) alphas and analyzed their relationship to expense ratios. There was again a significant dispersion in the results (See chart below). Consistent with other research, higher expenses generally were associated with lower (or negative) net alphas.

Higher ESG fund management expenses tend to be associated with lower net alpha

Higher ESG fund management expenses tend to be associated with lower net alpha
Notes: Relationship between net alpha and average over monthly expense ratios. Mostly expense ratios are calculated as the difference between gross and net returns. The exhibit includes data from the five-year periods: 2004 to 2008, 2009 to 2013, and from 2014 to 2018. Funds are those focused on U.S. equities using ESG as a factor in their investment process, as identified by Morningstar. Benchmark is FTSE USA Equity All Cap.
Sources: Vanguard calculations based on data from Morningstar, Inc.
© 2020 Pageant Media. Republished with permission of PMR Journal of Portfolio Management. Have investors paid a performance price? Examining the behavior of ESG equity funds, Vol 46, Issue 3 Ethical Investing 2020. For more information, please visit www.PM-Research.com. All rights reserved.

The key takeaway: There is a lot of variability in the way ESG strategies perform. "Given these differences in risk-return outcomes and the high degree of heterogeneity in the construction and management of ESG funds," Mr. Grim said, "investors should assess potential investment implications on a strategy-by-strategy basis."

DOL rule regulates ESG investing in 401(k) plans

It's important to note that how investors evaluate ESG-oriented funds is similar to how we would expect them to evaluate other investments that seek to either mitigate risk exposure or enhance returns by restricting holdings to a subset of the market. Despite this, the DOL's original proposed rule would have treated ESG products differently from other investments under ERISA's investment duties regulation. The final rule no longer places particular burdens or restrictions on ESG funds per se, but instead focuses a fiduciary's evaluation of an investment on "pecuniary factors." The rule could have an effect very similar to the proposal by placing significant burdens on plan sponsors and investment managers when an investment or an investment course of action takes into account ESG or similar factors.

"We see no basis for singling out ESG factors for increased regulatory scrutiny. Under the final rule, plan fiduciaries may be reluctant to invest in or make available ESG-oriented funds without clear evidence that the use of such funds does not sacrifice investment return," said Natalie Bej, head of U.S. Regulatory Affairs at Vanguard. "In our comment letter, we expressed the view that investors should be allowed to make informed investment decisions based on transparent and effective disclosure requirements that apply to all plan investments, including ESG funds."

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • ESG funds are subject to ESG investment risk, which is the chance that the stocks or bonds screened by the index sponsor for ESG criteria generally will underperform the market as a whole or that the particular stocks or bonds selected will, in the aggregate, trail returns of other funds screened for ESG criteria.
  • Figures are as they appear in the Journal of Portfolio Management.