min read

ESG funds have not been performing, is responsible investing dead?

ESG is reaching a inflection point where trade offs are becoming known.

Global exchange-traded "sustainable" funds that publicly set environmental, social, and governance (ESG) investment objectives had more than $2.7 trillion in assets under management as of December 2021; 81 percent were European-based funds and 13 percent were American-based funds. Alone in the fourth quarter of 2021, 143 billion dollars of new capital entered these ESG funds.

How did investors perform? Not very well, it appears.

Initially, ESG funds have a terrible financial performance. In a recent Journal of Finance article, researchers from the University of Chicago analyzed the Morningstar sustainability ratings of over 20,000 mutual funds representing over $8 trillion in investor assets. Although the funds with the highest sustainability ratings attracted more capital than those with the lowest ratings, none of the funds with the highest sustainability ratings outperformed the funds with the lowest ratings.

This outcome could be anticipated, and it is possible that investors would be willing to forego financial returns in exchange for improved ESG performance. Unfortunately, ESG funds do not appear to provide superior ESG performance.

Columbia University and London School of Economics researchers compared the ESG performance of U.S. companies in 147 ESG fund portfolios and 2,428 non-ESG portfolios. They discovered that the ESG portfolio companies were less compliant with labor and environmental regulations. In addition, they discovered that companies added to ESG portfolios did not improve their compliance with labor or environmental laws.

This is not a singular observation. A recent European Corporate Governance Institute paper compared the ESG scores of companies invested in between 2013 and 2017 by 684 U.S. institutional investors that signed the United Nations' Principles of Responsible Investment (PRI) and 6,481 institutional investors that did not sign the PRI. They detected no improvement in the ESG scores of companies held by PRI signatory funds after their signature. Moreover, financial returns were lower and risk was greater for PRI signatories.

Why do ESG funds perform so poorly? In competitive labor markets and product markets, corporate managers attempting to maximize long-term shareholder value should already be paying attention to employee, customer, community, and environmental interests. Consequently, establishing ESG objectives may actually distort decision making.

There is also evidence that companies publicly embrace ESG in order to conceal poor business performance. Ryan Flugum of the University of Northern Iowa and Matthew Souther of the University of South Carolina reported in a recent paper that when managers underperformed the earnings expectations (set by analysts following their company), they frequently discussed their commitment to ESG. However, when they exceeded earnings expectations, they made few, if any, ESG-related public statements. Therefore, sustainable fund managers who direct their investments to companies that openly embrace ESG principles may overinvest in financially underperforming companies.

The conclusion that can be drawn from this evidence seems fairly obvious: funds investing in companies that publicly embrace ESG sacrifice financial returns without advancing ESG interests significantly, if at all.


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