What do investors search for once they buy environmental, social, and governance (ESG) equity index funds? In principle, as in any fund investment decision, it could possibly be higher financial returns, greater portfolio diversification, reduced volatility, etc.
But whatever investors hope ESG funds deliver, they likely expect them to perform higher on ESG criteria than their alternatives. In spite of everything, why call the funds “ESG” in the event that they don’t take ESG aspects into consideration of their investment decisions?
The difficulty is just not just academic. ESG funds, including each mutual funds and exchange-traded funds (ETFs), have grown right into a $400 billion market in the US alone.
Step one in testing whether ESG funds deliver higher ESG scores is to find out what to check them against.
Many ESG funds track ESG indexes which are often provided by such third-party index creators as MSCI and S&P. For instance, the SPDR S&P 500 ESG ETF is managed by State Street, has $715 million in assets under management (AUM), and is listed under the ticker EFIV. EFIV “seeks to offer investment results that, before fees and expenses, correspond generally to the S&P 500 ESG Index,” in keeping with its latest publicly available factsheet.
The S&P 500 ESG Index itself “is a broad-based, market-cap-weighted index that’s designed to measure the performance of securities meeting sustainability criteria, while maintaining similar overall industry group weights because the S&P 500,” in keeping with its latest factsheet from S&P Global.
The S&P 500, after all, is the usual market capitalization-weighted stock market index and serves because the benchmark for a lot of index funds.
The S&P 500 ESG Index factsheet terms the S&P 500 its “benchmark” and compares its price performance to the S&P 500. Eight of the highest 10 holdings of the S&P 500 ESG Index are also among the many top 10 of the S&P 500. In truth, the identical 4 firms — Apple, Microsoft, Amazon, and Nvidia — in the identical order, are listed as the highest 4 holdings of every.
For the reason that SPDR S&P 500 ESG ETF tracks an ESG index, which itself tracks a market index, whether the ESG index has a better ESG rating than the benchmark S&P 500 must be of interest. The ESG designation, in spite of everything, is the important thing distinction between the 2 indexes. Nevertheless, the factsheets didn’t include ESG scores for these funds.
So to approximate their ESG scores, we took the highest 10 holdings of every and manually calculated a cap-weighted rating through the use of each company’s publicly available ESG rankings from MSCI and Sustainalytics.
We averaged the 2 rating agencies’ results and located that the S&P 500 ESG Index had a cap-weighted ESG rating 6.0% higher than the S&P 500.
ESG Scores: ESG Indexes vs. Market Indexes
We repeated this exercise with 19 other popular ESG indexes. In each case, we verified that the ESG index compared its performance to a mainstream market index and calculated the ESG “uplift” over the benchmark on the idea of the highest 10 holdings in each index.
To make sure, the highest 10 holdings are an imperfect proxy for the general index, but the businesses in query do account for a mean 25% and 31% of the overall capitalization of the market indexes and the ESG indexes, respectively. Furthermore, ESG index creators would presumably wish to select firms with the very best ESG rankings for his or her largest holdings, provided that didn’t create too large a tracking error relative to the benchmark. Such a range process would further increase the apparent improvement in ESG criteria of the ESG index over its mainstream market benchmark.
ESG Index ESG Rating Improvement vs. Market Index
Our key finding, nevertheless, is that the ESG indexes typically had only marginally higher ESG scores than their parent market indexes. Some ESG indexes had even less ESG value since their cap-weighted scores were lower than those of their parent.
While the range of variation between ESG indexes and market variation was wide, from -26% to +43%, most deltas fell within the 0 to 10% band with an overall average of 8.3%.
Whether the narrow margins of the ESG rating improvements are material or not is an issue for every fund’s investors. But when investors should not have this information, they can’t answer the query.
Investors pay 40% higher fees on average for sustainable funds than non-ESG funds. But in keeping with our research, if investors think that higher fees buy much higher ESG scores, they need to reconsider.
Should you liked this post, don’t forget to subscribe to Enterprising Investor.
All posts are the opinion of the creator. As such, they mustn’t be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the creator’s employer.
Image credit: ©Getty Images / george tsartsianidis
Skilled Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and self-report skilled learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.
