Responsible investing has become a hot topic in financial markets in recent years with many investors racing to integrate Environmental, Social and Governance (ESG) issues into their investment process. This has coincided with a greater awareness of climate change, social responsibility and the importance of well-managed, diverse companies.
In fact, one in four dollars of professionally managed assets in the US are currently in socially responsible investments1, despite the lack of standardisation when it comes to defining, measuring and scoring E, S, and G factors in investments. So while interest and investment in these types of funds have risen, are those labelled ESG materially different from non-ESG focused funds?
In the latest instalment of our ‘3 Point Perspective’ series, our Quantitative Portfolio Strategy team highlights the main conclusions of their recent study examining whether US domiciled equity mutual funds and ETFs with an ESG label differ from conventional funds in terms of their holdings and factor exposures.
ESG funds have attracted a higher percentage of inflows than other equity funds
An ESG label has become a key characteristic for attracting investors’ capital. In looking at data since 2013, we find that ESG funds in the US have, on average, enjoyed inflows of about seven percent per year, while non-ESG ones experienced yearly outflows of two percent.
In fact, they have attracted a higher percentage of investors’ money in every year since 2013, while their non-ESG counterparts have suffered outflows every year since 2015 despite robust stock markets during this period.
ESG US equity funds have attracted more inflows since 2013
Note: The sample period is from January 2013 to February 2020. Flows (in %) are averaged by month and fund type, and then averaged by year and annualised by multiplying by 12. Funds with AUM larger than $100mn are included in the sample. Flows are truncated at the 2nd and 98th percentile.
Source: EPFR, Barclays Research
Growth has been driven by interest in sustainable investing rather than superior performance
The rise in inflows does not appear to have been driven by performance given ESG funds have delivered roughly similar returns to other equity funds since 2013.
Returns have been similar, with ESG funds only slightly outperforming in the past 2 years
Note: The sample period is from January 2013 to February 2020. The Figure displays total returns (net of fees), where returns are averaged by month and fund type. Funds with AUM larger than $100mn are included in the sample.
Source: EPFR, Barclays Research
Instead, we believe that greater investor interest in the values of ESG investing has been the driving force. As interest has grown, so has the number of investment options, with the total number of ESG funds growing significantly since 2006, and total assets under management rising to about 0.7% of the total market capitalisation of all US stocks.
This interest has also meant that ESG-focused funds have been able to charge higher fees compared with conventional funds.
Average and median expense ratios by fund type
Note: The sample period is from January 2013 to September 2019, and comprises all ESG and non-ESG US equity funds. ESG funds with AUM larger than $10mn and at least 2 years of data are included in the sample.
Source: EPFR, CRSP, Barclays Research
ESG-labelled funds do not necessarily provide more ESG exposure
To establish just how different portfolios of ESG funds are from conventional funds, we combed through two decades of funds’ holding data and scrutinised their exposure to investment styles (factors) and risk-adjusted performance.
Our conclusion? ESG funds are not really different from conventional funds in terms of holdings, risk exposures and therefore performance. This conclusion holds even for the subset of funds that changed their designation from non-ESG to ESG-focused2.
This reflects the fact that measuring a fund's ESG focus is everything but straightforward. There is a lack of consensus on how many and what aspects of E, S and G should be assessed in each relevant dimension, and as a result, different providers score ESG-related criterion differently. Additionally, many stocks, especially small caps, are not yet ESG-rated. What score to assign to these companies is an open issue and may affect the classification of ESG funds.
Beyond this, the overall ESG score of a fund is a composite of its individual E, S and G scores, but there may be little correlation between the individual pillars. A fund may have a high environmental impact score by overweighting low carbon emissions, but rate low on social impact, resulting in an average ESG score overall.
The need for transparency and standardisation
Our findings have important implications for portfolio managers, investors and regulators about how to measure, invest in and compare ESG funds. Portfolio managers need to be more transparent about why their products qualify as sustainable. Investors need to do far more due diligence to ensure that their investments do indeed align with their objectives.
As for regulators, the introduction of policies to standardise ESG data production and reporting, as well as to require portfolio managers to transparently communicate about both the portfolio construction and performance attribution of ESG-labelled funds could go a long way toward mitigating current issues around ESG definition, measurement and scoring.
1 Social Investment Forum, 2018
2 Fund holdings: we averaged the ESG scores of individual securities held in each fund, and then averaged ESG scores by fund type. We found that portfolios of ESG funds have higher, but not significantly different, ESG scores than non-ESG funds. Risk-adjusted returns and factor-loading: here, too, we found that ESG funds are similar to conventional funds. Non-ESG funds that switched to an ESG investment objective: according to one ESG score provider, the rise in the ESG score is economically, but not statistically, significant. According to another, the score remains flat, suggesting no discernible change in the ESG exposure.
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Our ESG Research Team supports the three core approaches used by investors to integrate ESG into their portfolios.
About the analysts
Arik Ben Dor is a Managing Director and Head of Quantitative Equity Research at Barclays. For nearly two decades, Dr. Ben Dor oversaw large scale research projects in equities, rates, credit, and hedge funds used by the largest institutional investors globally. He has co-authored two books on quantitative investing in credit securities and over a dozen articles in leading industry journals. He is a member of the Journal of Portfolio Management Editorial Board and an Associate Editor of the Journal of Fixed Income.
In 2018, he was ranked 1st in the Institutional Investor All-America Fixed Income Research survey in the Quantitative Analysis category. Prior to Barclays, Dr. Ben Dor worked at Lehman Brothers and Morgan Stanley. He holds a PhD in Finance from the Kellogg Business School at Northwestern University, and completed both his B.A. and M.A. in Economics from Tel Aviv University, Cum Laude.
Carlo Rosa is a Director in the Quantitative Portfolio Strategy group at Barclays Research. Based in New York, he focuses on the development of quantitative equity strategies. Before joining Barclays in 2017, he was a senior economist at the Federal Reserve Bank of New York and prior to that an assistant professor of finance at the University of Essex.
Mr. Rosa's research covers asset pricing, empirical finance and monetary economics. He has published in a number of leading academic journals, including the Journal of International Economics, Journal of Banking and Finance, Journal of Empirical Finance and International Journal of Central Banking. Mr. Rosa holds a PhD in Economics from the London School of Economics.