Scientific Beta: Sustainability alpha in the real world

5 december 2023

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

Assessing the performance of sustainable investing from a value-weighted portfolio of exchange-traded funds that follow systematic ESG investing strategies in the US equity market, we find that sustainable investing did not deliver higher returns than standard index funds.

Widely commented periods of outperformance, such as the year 2020, can be explained in large part by industry effects, such as a tilt towards technology stocks. Over the past decade, such periods of outperformance are offset by corresponding periods of underperformance, leaving ESG investors with returns of -0.2% compared with the market index and -0.7% compared with a benchmark with matching industry exposure.

Sustainable Investing Portfolio

In recent years, there has been growing interest in sustainable investing, which integrates non-financial considerations such as ESG criteria in investment decisions.

A key concern for all investors is whether integrating non-financial considerations has an impact on financial performance. However, assessing the realised impact on performance is difficult due to the existence of disparate approaches to define and capture sustainability.

In recent research[1], we address this problem by constructing a monthly rebalanced portfolio based on historic data, the Sustainable Investing Portfolio, composed of sustainable ETFs that invest in the US equity market. This portfolio reflects real ESG approaches available on the market, weighted by their popularity. Therefore, it provides a more representative and less arbitrary assessment of the impact of sustainability on performance than stylised strategies.

In addition, this portfolio only invests in products that adopt systematic approaches to tilt toward ESG. This gives us results that are not polluted by confounding effects, such as fund managers’ skill in picking stocks or in timing the market.

Our results show that, over the past decade, the Sustainable Investing Portfolio did not outperform its benchmarks. If anything, realised returns of the Sustainable Investing Portfolio were marginally lower than its benchmarks. Indeed, average annual returns were 0.2% lower than the proxy for the US equity market, and 0.1% lower when we account for the portfolio’s market risk exposure. Removing industry factors’ contributions reduces performance even more – annualised industry-adjusted returns are -0.7% on average.

Breaking down the performance into shorter time periods (the last ten calendar years), we identify one year (2020) characterised by large outperformance over the market (+4.2% in relative returns and CAPM alpha). However, this short-term extra-performance represents just a statistical outlier. Furthermore, more than 50% of the outperformance in 2020 is attributed to exposure to industry factors, which do not require ESG information, so this outlier is mostly due to sector biases rather than to the ESG-tilt of the sustainable ETFs.

Conclusion

Overall, the evidence from real-world investment products shows that sustainability did not generate ‘sustainability alpha’ over the past decade. For investors looking to integrate ESG objectives in their investment process, it is crucial to question what impact this would have on their portfolio’s financial performance. The existence of numerous methodologies to integrate sustainability, which may not be representative of actual practice, has made it challenging to assess this impact empirically. Our research provides an assessment of the ‘real world’ performance of sustainable investing, drawing on information from the market of exchange-traded funds.

We encourage investors to consider such 'real-world' results and be aware of the limitations of analyses that select particular funds or create stylised strategies that may not reflect options actually available to sustainable investors.