Beyond the Label, ESG Funds May Miss Their Mark


KEY TAKEAWAYS
  • Components of ESG in an investment strategy, how they’re measured, and the method of incorporation can lead to a wide range of investment outcomes.
  • ESG strategies exhibit a broad spectrum of characteristics, which may drive expected returns that differ from the market.
  • Greenhouse gas emissions exposure has varied substantially across ESG strategies, highlighting the importance of looking beyond ESG labels to determine whether an ESG investment is consistent with one’s goals.

The absence of a universally accepted definition of environmental, social, and governance (ESG) investing has resulted in a broad array of approaches.This presents a potential dilemma for investors, as the components of ESG considered in an investment strategy, variables by which they are measured, and the method of incorporation can lead to a wide range of investment outcomes. Our study of US-domiciled ESG-focused funds highlights a variety of both fund characteristics and sustainability profiles, a reminder that investors may need to look beyond ESG branding to evaluate whether an investment approach is consistent with their goals.


Many Flavors to ESG Investing

The first sign of a varied ESG investment landscape is the breadth of investment categories among ESG-focused strategies. Exhibit 1 shows the Morningstar category breakdown for a sample of US equity mutual funds and ETFs categorized as “Sustainable Investments” as of June 30, 2021. While the majority of the $214 billion in this sample’s assets under management (AUM) is focused on large cap stocks, the 196 ESG funds are spread across 17 categories spanning size, style, and sector composition. In contrast to the mutual fund industry at large, the majority of these ESG funds are actively managed; less than 40% by net assets were categorized as index funds.


Exhibit 1

Variety Show

US equity funds with a sustainability focus, percentage of AUM by Morningstar category, as of June 30, 2021


While research suggests ESG characteristics do not provide additional information about expected returns (Bebchuk et al., 2013; Blitz and Fabozzi, 2017; Dai and Meyer-Brauns 2020; Polbennikov et al., 2016), an emphasis on ESG characteristics might impact the performance of ESG strategies. For example, if the incorporation of ESG considerations leads to a systematic over- or underweighting of drivers of expected returns, such as size, relative price, or profitability, the expected returns of ESG strategies may be systematically higher or lower than the expected return of the market.

Viewed in aggregate, ESG-focused US equity funds differ from the broad US market. Characteristics for an asset-weighted sample of ESG funds as of June 30, 2021, in Exhibit 2 show a tilt toward higher relative price and smaller market capitalization than the Russell 3000 Index. Interestingly, the number of distinct US stocks included in the aggregate ESG sample totals more than 2,800, approaching the index’s 3,009 holdings. This implies that, depending on whom you ask, more than 90% of stocks in the US market fit the bill for ESG investing.

Aggregate characteristics obscure the range of outcomes across ESG strategies. Exhibit 2 also shows characteristics for the cross-section of ESG funds at the 25th, 50th, and 75th percentiles of the distribution. Portfolio positioning runs the full spectrum along all three characteristics. In particular, the interquartile range of weighted average market cap spans from a market-like $466 billion down to under $27 billion, the latter bordering on mid cap territory. The observed variation in size, relative price, and profitability implies meaningful differences in expected returns among these funds.


Exhibit 2

All Shapes and Sizes

US equity sustainability funds aggregate characteristics, as of June 30, 2021


In addition to the broad range of individual fund characteristics, the results indicate many ESG funds select only a small subset of companies, an approach that leads to a limited investment universe and lower diversification. For example, Exhibit 2 shows that, at the 25th percentile, the number of stocks held in a sustainability fund is just 36.

With so many approaches to ESG investing, one might expect substantial variation when assessing strategies through the lens of any individual ESG measure. This is exactly what we see in the greenhouse gas (GHG) emissions exposure data for our sample of ESG funds. As shown in Exhibit 3, both the emissions intensity and potential emissions of ESG funds in aggregate are meaningfully lower than those of the broad market. But the range of reduction is considerable. For example, for the 75th percentile of funds, emissions intensity is 7% lower than that of the Russell 3000 Index; by comparison, the reduction is 58% at the 25th percentile.


Exhibit 3

Looking Under the Hood

Emissions exposure for the US equity sustainability fund sample, as of June 30, 2021


The emissions results are instructive in the context of investor expectations. The latest science2 unequivocally pinpoints GHG emissions as the primary contributor to climate change. And data on GHG emissions are widely available for public companies (Chi, Geffroy, Thornton, and Whittington, 2021). To the extent that investors expect an ESG investment to reflect their concerns over environmental sustainability, the wide gamut in emissions exposure outcomes may be disappointing.


A Road Map for Change

Our findings show that the ESG label is hardly prescriptive when it comes to investing, highlighting the importance of evaluating an investment approach based on one’s goals. Those with concerns over climate change may seek out strategies with reduced exposure to companies and sectors that drive climate change through carbon emissions. That means asking questions of the investment managers to evaluate which ones have delivered on the claim of reducing exposure to emissions vs. simply paying lip service.

Investors should also be wary of claims by ESG managers that their sustainability funds will meaningfully impact climate change. There is a distinction between GHG emissions exposure in one’s asset allocation and actual GHG emissions in the real world: just because you’re not holding shares of a company doesn’t mean it stops burning hydrocarbons. As a result, while managers may use divestment to avoid companies with high greenhouse gas emissions, this does not mean that these types of strategies necessarily have a real-world impact. Investors should make sure that managers claiming to have actual real-world impact can provide objectively measurable reporting that backs up their claims.



A Science-Based Approach to Sustainability Investing
 

Many people want to align their environmental views with their portfolio objectives. Dimensional’s sustainability strategies are designed to target measurable sustainability goals while seeking broad diversification, efficient cost management, and higher expected returns.

Learn more about our approach



Glossary

Relative Price: Refers to a company’s price, or the market value of its equity, in relation to another measure of economic value, such as book value.

Profitability: A company’s operating income before depreciation and amortization minus interest expense scaled by book equity.

Price to Book: The ratio of a firm’s market value to its book value, where market value is computed as price multiplied by shares outstanding and book value is the value of stockholders’ equity as reported on a company’s balance sheet.

Market Capitalization: The total market value of a company’s outstanding shares, computed as price times shares outstanding.

Asset-Weighted Sample: A sample that weights each fund in proportion to its fund assets under management.

Footnotes

  1. 1See Berg, Kölbel, and Rigobon (2020) and Chi, Geffroy, Thornton, and Whittington (2021).

  2. 2Per the Intergovernmental Panel on Climate Change 2021 study: AR6 Climate Change 2021: The Physical Science Basis — IPCC.

References

Bebchuk, Lucian A., Alma Cohen, and Charles C.Y. Wang. 2013. “Learning and the Disappearing Association Between Governance and Returns.” Journal of Financial Economics 108, no. 2: 323–348.

Berg, Florian, Julian F. Kölbel, and Roberto Rigobon. 2020. “Aggregate Confusion: The Divergence of ESG Ratings” (SSRN working paper no. 3438533).

Blitz, David, and Frank J. Fabozzi. 2017. “Sin Stocks Revisited: Resolving the Sin Stock Anomaly.” Journal of Portfolio Management 44, no. 1: 105–111.

Chi, Joseph, Eric Geffroy, Jeromey Thornton, and Jim Whittington. 2021. “ESG Data, Ratings, and Investor Objectives.” Dimensional Fund Advisors (article).

Chi, Joseph, Mathieu Pellerin, and Jacobo Rodriguez. 2020. “The Economics of Climate Change.”  Dimensional Fund Advisors (research paper).

Dai, Wei, and Philipp Meyer-Brauns. 2020. “Greenhouse Gas Emissions and Expected Returns.” Dimensional Fund Advisors (research paper).

Polbennikov, Simon, et al. 2016. “ESG Ratings and Performance of Corporate Bonds.” Journal of Fixed Income 26, no. 1: 21–41.

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