Are ESG Funds A Good, Long-Term Investment?

One of the hottest investment trends promises to do well while by doing good. This investment trend is called environmental, social, and governance investing, or ESG funds. Not all ESG funds have similar investment strategies.

Some ESG funds actively invest in companies that meet specific environmental or social criteria. These funds will only invest in clean tech companies for instance, or only in companies where sufficient numbers of women are in leadership positions. Other ESG funds will be, for all intents and purposes, broad-based funds that simply reject targeted investments, such as oil and gas, gun, and tobacco companies.

In recent years, ESG funds have been presented to investors as being socially responsible and a good investment that has outperformed their respective benchmarks in the short-term. Of course, as financial advisors’ counsel, financial risks, costs, and long-term performance also matter.

This begs the question – accounting for all of these considerations, how have ESG funds performed over the long-term?

A new Pacific Research Institute study puts this question to the test, analyzing ESG funds that have either existed for more than 10 years, or outperformed more traditional S&P 500 funds in the short-term.

Looking at the 18 funds with a 10-year track record, the study concludes that, based on the 10-year growth rate through April 2019, an equal-weighted $10,000 investment in these funds would be 43.9 percent smaller than a similar investment made in an S&P 500 index fund.

Reviewing the historical record of the individual ESG funds, only one would beat a traditional S&P 500 Index fund over 5 years, while only two would have surpassed the Index funds’ performance over 10 years.

The ESG funds studied also carried a higher risk. This is because they were found to be less diversified in their portfolio holdings than broader investment funds. Consider that 37 percent of the ESG fund dollars were allocated to the top 10 holdings on average. This compares to 21 percent in a broader S&P 500 index fund.

ESG funds also have higher costs for investors. The study found that the average expense ratio for ESG funds was 0.69 percent, compared with just 0.09 percent for S&P 500 index funds. Keep in mind that higher expenses mean less total return for investors.

This is not to suggest that ESG investing is necessarily the wrong choice for individual investors. These funds have a place for individuals who are passionate about making social or environmental change. ESG criteria, particularly the good governance criteria, can also provide information regarding management’s effectiveness. However, the long-term record suggests that investors risk higher costs, greater volatility, and lower returns from investing in ESG funds.

While appropriate for individuals, who will bear the financial consequences of their own decisions, ESG investments are inappropriate for public pension funds despite the recent push by activist investors and proxy advisory firms for public pension funds to apply ESG criteria in their investments.

Public pension funds have a fiduciary responsibility to public sector workers and retirees; a diverse group of investors who cannot exit the relationship and may hold differing views about complex social issues. These funds also have a responsibility to taxpayers who will, ultimately, bear the costs from any investment underperformance. Public pension investment decisions must be guided by the funds’ prime directive – to meet its financial obligations to future retirees.

Doing financially well and socially good by investing in ESG funds is laudable. But it shouldn’t drive the investment decisions of pension funds, especially when so many are grappling with millions of dollars of unfunded obligations. Indeed, for pension funds the goal of doing well by doing good should only mean this: providing for retirees and keeping the taxpayers’ financial burden in mind.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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