Wall Street’s latest bandwagon—or juggernaut—is ESG investing, which seeks to make businesses and the world [E]environmentally clean, [S]socially better and [G]Better over.
I suspect that most people who buy funds following this approach realize how much they are paying and how little they are getting. In the average ESG fund, effective fees can be three times the reported fees, according to a new study. That’s because these funds—which are also often touted as green, sustainable, or responsible—are nowhere near as pure as they’d like to be.
In the five years ended December 31, investors added an estimated $64.6 billion to mutual funds and exchange-traded funds using ESG strategies to invest in US stocks. Meanwhile, investors pulled $92.2 billion out of all other United States stock funds.
While some ESG funds take a conservative or even “biblically responsible” approach that favors industrial and other old-fashioned sectors, most seek to avoid companies that emit excessive pollution, precious consume natural resources, rattle labor unions, undermine gender equality, and so on.
The inevitable result: They favor software and healthcare while leaning away from oil and gas.
Sustainable US stock funds have 22.1% of their assets in technology and 15.4% in healthcare, but only 2.6% in energy, according to Morningstar. Non-ESG funds, meanwhile, hold 18.7% in tech, 14.3% in healthcare, and 5.7% in energy.
No wonder green funds averaged 8.1% annualized returns over the past five years, while nonsustainable funds rose 6.9%. For most of that period, technology and healthcare boomed, while energy lagged behind.
Last year, however, tech went into the tank along with most of the market, while energy stocks were among the only winners. Green funds lost 19.7%, worse than traditional funds, which fell 18.1%.
In 2015, an analysis of more than 2,000 research papers yielded surprising results. More than half of the studies on corporations have found that those adopting ESG principles have improved their financial results. But only one out of six studies on ESG funds found that these portfolios performed significantly better than average.
Perpetual shares may be bid up to unsustainable prices, reducing the future returns of funds holding them. Perhaps ESG funds are bad at picking “good” companies.
Or maybe green portfolios are investing almost exactly like their non-ESG counterparts – incurring higher costs for doing the same things as funds that don’t pretend to wear a halo.
Look at the top holdings of most sustainable funds and you’ll see the same names: Apple Inc., Microsoft Corp., Google parent Alphabet Inc., UnitedHealth Group Inc., JPMorgan Chase & Co. S&P 500.
The average green U.S. stock ETF charges 0.17% in annual fees, according to Morningstar — 0.05 percentage points higher than traditional funds.
It doesn’t sound so bad until you triple it.
On average, ESG funds invest 68% of their assets in the same “similar” holdings as non-ESG funds, according to a new Harvard study.
So, for every dollar you invest in a responsible fund, only about 30 cents go into stocks that you couldn’t find in a fund that makes no pretense of trying to make the world a better place.
Although only a third of your money in the average ESG fund is explicitly “green,” you charge a fee on the entire portfolio. of portfolios,” says Harvard Business School finance professor Malcolm Baker, one of the study’s authors.
According to Morningstar, almost all variation in the returns of traditional US stock funds can be explained by the movement of the S&P 500. Their average score on a statistical measure of similarity called R-squared is 0.95.
Among green funds, the average R-squared relative to the S&P 500 is 0.98.
Responsible portfolios are no less like the overall market than traditional funds. They are liking it even more.
This is partly because non-ESG funds tend to own smaller stocks. But with green funds, on average, acting 98% like the mainstream stock market, you’re kidding yourself if you think they’re a different way to invest.
Asset managers love ESG because it generates hefty fees and because the money is “sticky”.
As my colleague James McIntosh explained in a series last year, you don’t punish “bad” companies by abstaining from their shares or reward “good” ones by buying their shares. Someone else will own the shares you sell or give away, while sky-high stock prices are no incentive to make better corporate decisions.
If, in spite of all this, owning an ESG fund still makes you feel like you’re on the side of the angels, then I think the warm glow might be worth paying for – an expensive watch or car to make you feel special. Can Just be sure you understand that the price you’re paying could be three times what’s written on the label.