Why ESG should not be marketed as delivering outperformance

Despite strong performance since the Global Financial Crisis

Tom Eckett

a row of windmills in a field

ESG ETFs have exploded in recent years and offer ETF issuers one way to differentiate from their competitors.

However, the jury is still very much out on whether investing in ESG can deliver outperformance despite ETF issuers and index providers claiming this is one of the advantages of these strategies.

Highlighting this, the world’s largest asset manager BlackRock said in a report in 2018 “it is feasible to create sustainable portfolios that do not compromise return goals and may even enhance risk-adjusted returns in the long run”.

Research of this kind has become a staple part of the investment narrative when issuers are selling ESG products and there is a good reason for this.

ESG ETFs have delivered stellar returns since the Global Financial Crisis. For example, the MSCI World ESG Leaders index has returned 5.21% versus 5.08% for the MSCI World since 28 September 2007.

As AQR Capital’s founder and CIO Cliff Asness said in a post in 2017: “Employing these constrains is often promoted as enhancing expected returns.

“That is, if you avoid certain companies, industries, and even countries, that are deemed non-virtuous, you should expect to make more money over time.

“This seems to arise from investment managers selling virtue as a free lunch, and from investors who very much want to believe in that story.”

When looking at the drivers of ESG ETF returns, one can see they have benefited from a sector tailwind since the GFC.

ESG ETFs overweight the technology sector while underweighting energy stocks which have underperformed significantly over the past decade.

Furthermore, from a factor perspective, Nicolas Rabener, founder and CEO at FactorResearch, explained ESG products are long quality and low volatility while shorting the value factor. It is well documented value’s miserable performance since 2008.

As Matt Brennan, head of passive portfolios at AJ Bell, added: “It is hard to isolate if the ESG integration affected the performance, or whether it was due to the other unintended factor exposures.”

Therefore, investing in ESG should be understood for what it stands for; investing in companies that have a positive impact on the world.

Asness concluded: “In particular, accepting a lower expected return is not just an unfortunate ancillary consequence to ESG investing, it is precisely the point. As an ESG investor, this lower expected return is exactly what you want to happen and really the only way you can affect the change you seek.”


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