Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
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).
Before reviewing the results, the authors noted that a limitation of their methodology was that their categorization of stocks into socially responsible and non-socially responsible groups relied on whether a stock belonged to the MSCI KLD 400 Social Index.
Following is a summary of their findings:
- The fraction of the portfolio invested in socially responsible stocks (stocks belonging to the MSCI KLD 400 Social Index) was 29.0% – conventional funds hold a substantial fraction of socially compliant stocks.
- As one would expect, socially responsible portfolios are less diversified and include fewer stocks.
- The socially responsible component earned an annual net return of 12.95% and an annual net risk-adjusted performance of -0.70% versus an annual net return of 13.08% and an annual net risk-adjusted performance of 0.10% for the non-socially responsible component. The difference in annual returns between the socially responsible and non-socially responsible components was -0.13% or -0.81% (risk-adjusted using the Carhart model). Using the Fama-French model, the risk-adjusted difference in returns was -1.44% and was significant at the 1% confidence level. In addition, the risk-adjusted alpha for the non-socially responsible portfolio was also positive at 0.40% versus -1.04% for the socially responsible portfolio.
- The annual volatility of the socially responsible portfolio was higher at 17.5% versus 16.6% for the non-socially responsible portfolio.
- The Sharpe ratio of the non-socially responsible portfolio was higher at 0.96 versus 0.92 for the socially responsible portfolio. The difference was statistically significant at the 1% confidence level.
- The socially responsible and non-socially responsible returns showed a relatively low correlation (an r-squared of about 0.5). The low correlation provides a diversification benefit – the full portfolio has lower risk and a higher Sharpe ratio than either its SRI or non-SRI component. This was true despite the socially responsible portfolio having a higher volatility than the non-socially responsible portfolio.
- The results were robust to alternative approaches and categorizations of stocks (such as sorting by “sin stocks” and corporate social responsibility, or CSR, score).
- There was no evidence of persistence in performance in either of the two portfolios.
Their findings led the authors to conclude: “Portfolio managers of conventional portfolios derive superior performance from the non-socially responsible basket than from the socially responsible one.” However, they did add: “Despite a relative underperformance of socially responsible portfolios in comparison to non-socially responsible portfolios, one needs to notice that the magnitudes of the differences in raw performance (-0.13%) and risk-adjusted performance (-0.81%) are relatively small, and therefore may not deter ethically minded investors and managers from investing in SRI-related products.”
The low correlation of the socially responsible and non-socially responsible portfolios (about 0.5), and the finding that the full portfolio has less risk and a higher Sharpe ratio, also provide evidence that an SRI focus not only negatively impacted returns, it also increased portfolio risk, producing a less efficient portfolio. Again, SRI investors may be willing to accept that as a “cost” of expressing their values.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
The information presented herein is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information contained may be based on third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above you acknowledge that they are solely at your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by Buckingham regarding third-party websites. Buckingham is not responsible for the content, availability, or privacy policies of these sites, and shall not be responsible or liable for any information opinions, advice, products or services available through them. The opinions expressed by the featured author are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners® (collectively Buckingham Wealth Partners, “Buckingham”). LSR-21-40
1Depending on how you identify ESG assets, those numbers are considerably less.
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.