Good for You?

Robin Powell

IS SUSTAINABLE investing a fad? Everyone seems to be talking about it—not least product providers eager to persuade us that their sustainable funds are so much better, more ethical or more likely to outperform than everyone else’s.

Leaving aside the moral reasons for investing in funds that aim to deliver environmental and societal benefits, is sustainable investing a good idea financially? Do sustainable funds, otherwise known as ESG (environmental, social and governance) funds, deliver higher investment returns than their mainstream counterparts? What does the evidence tell us?

The first question to ask: Is there any reason high-sustainability companies should produce higher returns than low-sustainability firms? A study published in 2014 analyzed data from 180 of the largest U.S. companies between 1993 and 2010. The researchers concluded that high-sustainability companies “significantly outperform their counterparts over the long-term, both in terms of stock market as well as accounting performance.”

The authors of a German study published in 2015 reached a similar conclusion. Aggregating information from more than 2,000 studies, they found that “the business case for ESG investing is empirically very well founded.” They also showed how the positive correlation of high ESG scores and corporate financial performance appears stable over time, and manifests itself across different sectors and regions.

So far, then, the evidence is encouraging. High-sustainability companies tend to perform better. In theory, those who invest in them can expect higher financial returns.

There is, however, another side to the story. In a study published in 2009, Harrison Hong and Marcin Kacperczyk made a strong case for doing the exact opposite and investing instead in so-called sin stocks. There was, they suggested, a “societal norm” against, say, gambling companies and producers of alcoholic drinks and tobacco. As a result, they showed, such stocks are less likely to appeal to norm-constrained institutions like pension funds and thus their prices are relatively depressed. Lower valuations, of course, mean higher expected returns.

Investment author Larry Swedroe argues investors are better off investing in the whole market—including sin stocks—using low-cost index funds. He recently looked at three popular ESG indexes managed by MSCI. In each case, the ESG index had underperformed its mainstream equivalent since inception. What’s more, each of the mainstream indexes had a higher Sharpe ratio, meaning they also took slightly less risk.

But index providers use different selection criteria, and what’s true for one provider isn’t necessarily true for another. Recently, Ben Leale-Green from S&P Dow Jones Indices compared the performance of the S&P 500 Index with its ESG equivalent. Between May 2010 and July 2019, the excess return over the risk-free rate for the S&P 500 ESG Index was slightly higher than it was for the S&P 500. The annualized volatility of the S&P 500 ESG Index was also slightly lower.

Another major financial institution that advocates sustainable investing is Morningstar. Three years ago, it produced research which concluded that “the idea that sustainable investing is a recipe for underperformance is a myth.”

Keep in mind that sustainable investing is still relatively new, and we don’t have nearly as much historical data as we do for mainstream investing. That said, the evidence so far suggests that, if there is a performance penalty for sustainable investing, it’s a very small one.

As always, the most important thing to focus on when choosing a fund is cost. Simply put, the less you pay, the more you keep for yourself. Check out sustainable funds that are passively managed, such as iShares ESG MSCI USA ETF, iShares ESG MSCI EAFE ETF and Vanguard FTSE Social Index Fund. Active management is a zero-sum game before costs, and a negative-sum game after costs. The average sustainable investor using active funds must underperform the average investor using passive funds. It’s simple arithmetic.

Robin Powell is an award-winning journalist. He’s a campaigner for positive change in global investing, advocating better investor education and greater transparency. Robin is the editor of The Evidence-Based Investor, which is where a version of this article first appeared. His previous articles for HumbleDollar include Better Than TimingWriting Wrongs and Private MattersFollow Robin on Twitter @RobinJPowell.

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