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Home Mutual Funds

Why ‘Doing Good’ With Sustainable Investing Doesn’t Necessarily Mean Doing Well

MtR by MtR
July 23, 2021
in Mutual Funds
0
Why ‘Doing Good’ With Sustainable Investing Doesn’t Necessarily Mean Doing Well


Sustainable investing is increasingly popular among retail and institutional investors around the world. According to one recent industry study, sustainable investing accounted for $17.1 trillion of professionally managed assets in 2020 — and the growth continues.

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Among sustainable mutual funds and exchange-traded funds (ETFs) alone, global capital inflows during the first quarter of 2021 hit $185.3 billion. As Morningstar observed, “Sustainable funds represent a substantial and growing portion of the fund universe — in part due to the launches of new funds, and in part due to existing funds adding [sustainable] … factors to their prospectuses.”

This sustainable investing activity raises two key questions: First, what is meant by sustainable investing and, second, why is it increasingly popular? The answers to these questions point to the need for investors to be more discerning in their pursuit of sustainable investing — and their expectations for returns.

No Standard Definition

In seeking to answer the first question, we quickly discover that sustainable investing is a common term that usually refers to socially responsible investing (SRI) or environmental, social and governance (ESG) investing. Unfortunately, when sustainable investing is not used as a synonym for SRI or ESG, there is no common definition. A comparison of different investment companies and their publications reveals a variety of meanings and connotations when using these terms.

For example, some investment firms imply that sustainable investing is a strategy for maximizing portfolio returns; others state that sustainable criteria can minimize financial risk. In addition, some portfolio managers target firms with ESG best practices that meet the UN Sustainable Development Goals (SDGs). Portfolio managers and retail investors, alike, can also choose companies based on their ESG ratings, which are assigned by a variety of firms.

In addition, ESG investing strategies can be implemented by using two types of screens or filters, either singly or combined. Negative screens remove companies or sectors with poor ESG behaviors such as alcohol, tobacco, gambling, nuclear power, GMOs, weapons, and companies that engage in animal testing. Positive screens identify companies with good ESG behaviors, such as energy conservation, natural resources preservation, carbon neutrality, creating positive social impact through diversity and inclusion, board independence, and so on.

Clearly there is no consensus about the definition of sustainable investing. The result is confusion and sometimes contradictions for investors who want to invest their conscience with sustainable investments. Furthermore, it makes it difficult to interpret the $17.1 trillion invested in sustainable assets, as cited earlier; on what basis are these assets actually being managed?

Does Doing Good Mean Doing Well?

The second question — why is sustainable investing so popular? — raises a common assumption that investing in ESG mutual funds or ETFs translates into outperformance relative to the market. However, from over 2,000 academic studies taken together, the data reveal a different story.

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For individual company performance, there is a correlation between ESG scores and financial performance, such as return on assets and return on equity. Unfortunately, this link is based on correlation—not causality.

This can be confusing for those trying to compare financial performance with investment performance. As a result, too many pundits conclude from these results that highly rated ESG stocks or funds outperform their benchmarks, when this is not the case.

 As my colleague, Aaron Yoon, an assistant professor of accounting and information management at Northwestern University’s Kellogg School of Management, observed recently,  “there is no good way to quantify ESG programs’ link to stock returns.” The evidence indicates that, on average and on a risk-adjusted basis, ESG funds perform as well as their benchmarks — but neither better nor worse.

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One more thing to keep in mind: According to standard finance theory, there is a positive relationship between the risk of a security and its average return—in other words, the greater the risk, the higher the potential for reward (but, obviously, no guarantee). Numerous studies, however, have shown that when firms score high on environmental risk factors, their overall stock risk falls. Given this lower risk, it seems logical that even highly rated ESG securities should have lower-than-expected average returns.

From an investing perspective, it tells us that the performance of ESG investing is on par with non-ESG investing—which should come as no surprise, since hundreds of academic papers show that even standard active investing generally does not beat its benchmark. Why would we expect that investing along ESG criteria would somehow be the Holy Grail of superior returns? So, the bad news is that investors should not expect to realize market-beating returns, or alpha, merely from pursuing ESG investing.

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That said, ESG does not underperform either. For the investor, this is ultimately about setting expectations. If the primary motivation behind sustainable investing is about doing good, then that positive feeling is the unique value that ESG investing brings to the table, not superior returns.

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