ESG Mutual Funds Have Underperformed – But Just Barely

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New research shows that the environmental, social and governance (ESG) portions of a large sample of mutual funds underperformed the remainder of the funds and did so with higher risk. But the magnitude of those differences was small.

The increasing interest in ESG investing has led to a dramatic increase in cash flows into ESG strategies. According to the Global Sustainable Investment Alliance, ESG investing now accounts for more than $12 trillion, one out of every four dollars under professional management in the U.S., and one out of every two dollars in Europe.1

Sadok El Ghoul, Aymen Karoui, Saurin Patel and Srikanth Ramani contribute to the ESG literature with their December 2020 study, “The Green and Brown Performances of Mutual Fund Portfolios.” Their objective was to determine whether an ESG focus added or destroyed value among mutual funds. To accomplish this objective, they used a holding-based measure, decomposing mutual fund returns into socially responsible and non-socially responsible components – categorizing fund holdings based on a stock’s inclusion in a socially responsible stock index (the MSCI KLD 400 Social Index) and then computing the returns of each of the two subportfolios. That process enabled them to examine the difference in performance and assess the impact of socially responsible investing (SRI) on portfolio performance. Their data sample, from CRSP, included 2,129 actively managed U.S. equity funds with at least 80% of assets in stocks covering the period 2010 to 2017. To measure risk-adjusted performance, they used both the Carhart four-factor model (beta, size, value and momentum) and the Fama-French five-factor model (beta, size, value, profitability and investment).