Scientific Beta: Is fund selection risk an issue for ESG investors?

March 12, 2024

By Giovanni Bruno and Felix Goltz, Senior Quantitative Analyst and Research Director at Scientific Beta respectively

Although investors are increasingly incorporating ESG criteria into their investment practices, standards and definitions concerning ESG still remain contentious. What is the impact of this ESG confusion on financial performance?

In the past few years, investors have been showing increasing interest in integrating non-financial considerations, such as ESG criteria, into their financial decisions. The growth of the ETF market has fostered the adoption of such investment practices.

Today, ESG investors can choose from several ETFs that tilt towards sustainability and which employ systematic and transparent approaches. The appeal of these Sustainable ETFs is that they offer a cost-effective way to accommodate investors’ interest or preference for sustainability.

The problem of ESG confusion

While investors are incorporating sustainability criteria into their investment strategies, defining sustainability and identifying material ESG issues remain contentious. The absence of clear standards has led to a large disparity of metrics, a phenomenon commonly referred to as ESG confusion.

Investors interested in sustainable investing strategies must assess whether such confusion has an impact on financial performance. For example, we have recently examined the performance dispersion in the cross-section of a set of ESG funds invested in the US stocks.

Methodology

To conduct our analysis, we have constructed a dataset of sustainable ETFs, that is to say passive ETFs that have explicit ESG objectives. This dataset is built on readily available classification of funds as well as an analysis of the documentation of each fund. This way, only those funds that use ESG information in a systematic and transparent manner are included. By focusing on funds tracking systematic ESG indices, the confounding effects of manager skills are eliminated and any dispersion in performance can be imputed to differences in the ESG integration approach rather than to differences in discretionary choices of the funds’ managers.

Results

Our findings reveal substantial performance disparities in the cross-section of these ESG funds. Over a six-year period, the difference in annualised returns between the best and worst ESG funds is 6.5% when adjusting for differences in market exposure. When removing effects due to differences in industry exposure, the difference remains high with 4.9%. Over single years, the dispersion can be even more dramatic, reaching a maximum of 22.5% in terms of returns adjusted for market exposures, and 25.3% in terms of industry-adjusted returns.

This large dispersion shows that fund returns are not mainly driven by a common sustainability factor. Instead, fund returns largely depend on fund specific choices of how to integrate ESG information. This suggests that ESG investors face substantial fund selection risk. Importantly, traditional fund selection strategies like relying on past performance or tracking error are inadequate for predicting future ESG fund performance.

Towards harmonisation of ESG definitions?

Contrary to the notion of a common sustainability factor driving ESG strategies, our research underscores the presence of significant fund-specific risks. Evaluation of performance persistence shows that selecting funds based on past performance or tracking error fails to generate positive performance.

Overall, our findings reveal that fund selection risk is a material issue for ESG investors. It remains to be seen whether the industry will move towards harmonisation of ESG definitions and practices, a shift that would decrease divergence and ultimately reduce return dispersion. Our empirical results suggest that the current confusion of ESG practices translates to return dispersion that in turn creates risk for those investors who select among different ESG investing products.