In recent years, the focus on ESG investing (Environmental, Social, and Governance) has grown sharply. Investors want their portfolios to reflect their ethical values and sustainability goals. This article explores ESG funds’ performance, costs, and market dynamics, comparing them with non-ESG funds and examining their real impact on environmental and labor compliance. Key findings paint a complex picture: ESG funds often come with higher fees and show varied financial outcomes. Their ESG scores tend to reflect voluntary disclosures more than actual environmental or labor practices. Moreover, while green stocks have significantly outperformed due to climate shocks, this trend might not hold for future returns.
Specifically, the Finnish ESG fund market sheds light on risk-adjusted returns and growing market share, underlining the strong investor demand for responsible investments despite some short-term underperformance. This detailed analysis aims to give investors a clearer view of ESG investing’s present and future.
Key Takeways
- Discrepancy in ESG Scores vs. Practices: Studies show a big gap between some funds’ high ESG scores and their investments’ real-world compliance, hinting at greenwashing in the ESG fund industry.
- Varied ESG Fund Performance and Fees: Some ESG funds underperform and charge more than non-ESG funds, while others perform equally or better, challenging the view that ethical investments sacrifice financial return.
- Climate Shocks’ Effect on Green Stocks: Climate shocks have boosted green stocks’ performance over the past decade, leading to questions about future returns without these shocks.
- ESG’s Rising Market Share and Interest: Despite short-term dips, ESG funds are capturing more market share in Finland and worldwide, with strong investor interest in responsible investing signaling a shift towards more sustainable investment practices.
What does Research say about ESG Investing?
Raghunandan & Rajgopal (2022)
- Compliance and Emissions: ESG funds often held stocks in companies with poorer records in complying with labor and environmental regulations compared to non-ESG funds. However, these companies had higher ESG scores.
- Financial Performance and Fees: ESG funds tended to underperform financially compared to other funds within the same asset manager and year, and they generally charged higher fees.
- ESG Scores vs. Actual Performance: ESG scores were more correlated with the quantity of voluntary ESG-related disclosures, rather than with firms’ compliance records or actual levels of carbon emissions.
- These findings suggest a gap between the claims of ESG funds and their actual investment practices, raising concerns about greenwashing within the ESG fund industry.
Curtis, Fisch & Robertson (2021)
- Financial performance and fees: There is no significant evidence that ESG funds are more expensive in terms of expense ratios than non-ESG funds. Additionally, ESG funds do not seem to offer lower returns or higher risk compared to non-ESG funds. ESG funds might experience slightly better performance on average, both in terms of raw returns and risk-adjusted returns (measured by Sharpe ratios).
Pástor, Stambaugh & Taylor (2022)
- Financial performance: However, these high returns were attributed to unexpectedly strong increases in environmental concerns, not necessarily high expected returns.
- Greenium: Green assets can have lower expected returns due to investor preferences for environmentally friendly investments.
- Expected Returns vs. Realized Returns: There is a distinction between expected and realized returns for green assets. Green assets might show high realized returns due to specific market conditions or shifts in investor demand, their expected returns might be lower.
- Investors should be cautious when interpreting past performance of green assets as an indicator of future returns. Being ESG won’t probably lead into abnormal growth in the future.
ESG Investing Research summarized
While it is true that green stocks have outperformed their brown counterparts by 174 % in 2010s much of this has been due to so called climate shocks. These shocks can be things such as, bad news about climate change which increases investors interest in holding green stocks and hence increasing the ”Greenium” factor of green stocks.
The return difference between the Green and Brown stocks becomes flat or even slightly negative if there hadn’t been any climate shocks, or if the effect of climate shocks would have been zero, hence, it can’t be deduced whether green stocks will outperform brown stocks in the future since we can’t know about the amount and magnitude of future climate shocks, and their effect on the ”Greenium” factor.
How Well Have ESG Investing Funds Performed in the Mutual Fund Market
Historical performance of Finnish Global Equity ESG Investing funds (returns)
Long-term financial performance: On average, over a 10-year period, ESG funds have seemed to deliver slightly higher returns than conventional, non-ESG, funds. However, this may be due to a sort of ESG bubble in the markets and these returns may not be reflective of the underlying expected returns.
Short-term financial performance: Over the last five years, ESG funds have delivered lower returns than conventional funds. This difference has been especially evident over the last 12 months. This dip in short term performance may be explained by the relatively high valuations that ESG companies have enjoyed in the past. This left these companies with less room to grow. Tightening competition in the ESG space has also likely led to worse performance for ESG companies. Another possible driver for these lower returns is the tanking of tech company valuations in recent years. Many ESG funds hold large positions in tech companies, which may have led to worse performance over the last 3 years. Factors such as component scarcity following COVID and the Russian invasion of Ukraine destabilizing markets and driving inflation may also be key causes of these returns.
Risk adjusted returns of Finnish Global Equity ESG funds
Medium-term risk-adjusted performance: On average,over the last 5 years ESG funds have delivered almost identical risk-adjusted returns to conventional funds, as measured by Sharpe ratios. Some funds have delivered strong alphas, but these disappear on the aggregate level.
Short-term risk-adjusted performance: Over the last 12 months, ESG funds have lagged behind conventional funds in risk-adjusted returns significantly. This is due to a combination of increased volatility and lower returns on the aggregate level. Typically, ESG companies are innovative and less mature and require more debt financing than conventional companies. As a result, ESG companies have been hit hard by rising interest rates and lowered investor confidence.
Market share of ESG funds in Finland (Global equity funds) as of August 2023?
ESG funds market share of the total fund market:
ESG funds have not yet gained majority market share in this category: Whilst over the last few years ESG funds have gained significant market share and are a major force in the financial world, they have yet to gain a majority of funds under management.
The effects of ESG investing should however not be discounted: As of August 2023, ESG funds accounted for 40% of total assets under management in the study we are looking at. ESG funds are a critical component of the current financial space and will likely gain even more influence in the future. This will result in significant pressure for conventional funds to improve their ESG standards
ESG funds market share of net subscriptions:
Investor appetite for ESG investing seems high: ESG funds are growing at a huge rate. New subscriptions to ESG funds exceeded subscriptions to non-ESG funds by almost 500 million euros in January 2023. This clearly demonstrates that investors are very interested in investing in responsible.
ESG aspects likely to be crucial in the future: As investors start valuing responsibility in their portfolio companies more and more, companies will likely face significant pressure to conform to investor demands. Firms that refuse to take ESG factors more into account may be vulnerable to hostile takeovers by activist investors.
Bottomline
The exploration of ESG funds reveals a landscape filled with both promise and challenges. Investors seeking to align their portfolios with ethical and sustainable practices face the complexities of higher fees, mixed financial performance, and the nuanced reality behind ESG scores. Despite these hurdles, the enduring interest in ESG investing, particularly in markets like Finland, signifies a broader shift towards responsible investment strategies. This shift reflects a growing recognition of the importance of sustainability and ethical considerations in investment decisions.
As the industry evolves, it becomes clear that transparency, rigorous evaluation, and a commitment to genuine impact are essential for the future growth of ESG investing. The journey towards sustainable investing is ongoing, with each step forward marking progress towards aligning financial goals with global sustainability objectives.
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