Do ESG screens impact portfolio returns (good or bad)?
Many clients have a personal preference to incorporate sustainability screens into their portfolio. (Those who do not may wish to stop reading now!) These screens ensure their investments apply environmental, social and governance (ESG) criteria to all securities in their portfolio.
The earliest ESG funds started to appear around 15 years ago. Initially these funds were substantially more expensive than conventional funds, and there was uncertainty as to whether the returns would be better, worse, or the same as conventional funds.
We wrote a detailed article on the expected returns of ESG vs conventional funds a few years ago - https://loricapartners.com.au/insights/sustainable-investing. We wanted to update some of the data for investors who prefer to apply ESG screens to their portfolio.
Looking at the actual performance of a conventional fund, which has a directly comparable ESG alternative, is perhaps the most practical way to reflect on what investors can achieve with their own portfolio returns. It is difficult to find such comparable funds with a reasonable history of actual returns. But there is one.
Back in 2008, a U.S member of our Global Association of Independent Advisors approached Dimensional Fund Advisors to create a sustainable version of their largest U.S equity fund. Dimensional agreed, and we now have actual performance data for these two funds from 1 April 2008 to 31 December 2023 – a period of 15+ years, which is a meaningful timeframe.
The performance of these two funds over differing time periods to 31 December 2023 (net of fund costs and including dividends) are shown below:
Over 15 years, the ESG fund outperformed the conventional fund by 0.21% per annum. This means $1m would have grown to $5.02 million in the ESG fund vs $4.87 million in the conventional fund.
But if we had done this comparison 12 months earlier, the conventional fund would have performed slightly better. The ESG fund’s 2.73% outperformance in 2023 helped it nudge ahead again.
When we last did this analysis in 2019, again both funds had very similar returns since inception. But over the past few years we did see ESG funds outperform in 2020 when COVID hit, before conventional funds did better in 2022 when Russia invaded Ukraine. On both occasions the performance of the global energy sector impacted the relative performance of ESG and conventional funds, because in practice ESG funds do have an underweight allocation to energy stocks.
There is a statistic called standard deviation we use as a measure of risk for investments which records the price volatility of each fund. Since inception, the ESG fund had a standard deviation of 17.71 compared to the conventional fund at 17.54 – so no material difference in the variability of returns.
Whilst this analysis only looks at one fund, it is a good fund to consider as it holds 2,600+ of the biggest US stocks.
As noted above, the data set for reviewing the performance of sustainable strategies is nowhere near as large as for conventional investing, and some academics are yet to be convinced of the results.
Professor Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU, concluded the following:
“There is a weak link between ESG and operating performance (growth and profitability), and while some firms benefit from being good, many do not. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising.
“The evidence is stronger that bad firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks. ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good.”
[Author - If this quote confused you at first, you are not alone, but the suggestion is being a good firm does not in itself deliver strong performance, but by avoiding being a bad firm, which the adoption of ESG principles can help ensure, you can avoid your business being punished, which is beneficial to shareholders].
Lorica Partners offers both conventional and sustainable investment strategies for clients. For people wishing to incorporate sustainability principles into their portfolio, we can confirm there is no cost penalty (the conventional and ESG equivalent funds used by Lorica Partners have the same fund manager costs) and there is a high chance the returns will be similar over the longer term.
Author: Rick Walker