Don't overpay when investing in ethical funds

Everyone seems to be talking about sustainable investing right now. John Stepek recently looked at the difficulties of finding out exactly what's in your "ethical" fund. But putting aside questions of morality for a moment is investing with an eye on social impact a good idea financially? Do environmental, social and corporate governance (ESG) funds deliver higher returns than their mainstream counterparts? What does the evidence suggest?

The first question to ask is this: is there any reason why high-sustainability companies should produce higher returns than low-sustainability firms? The answer appears to be "yes". A study published in 2014 looked at data from 190 of the largest US companies between 1993 and 2010. It found that high-sustainability firms tended to conduct more long-term planning, and also measured non-financial criteria to a greater extent than their low-sustainability peers. The researchers found that such firms "significantly outperform their counterparts over the long-term, both in terms of stock market as well as accounting performance". A German study published in 2015 reached similar conclusions. Aggregating information from more than 2,000 studies, researchers found that "the business case for ESG investing is empirically very well founded". They also found that the positive correlation of high ESG scores and corporate financial performance appears stable over time, and across different sectors and regions.

The wages of sin are pretty decent too

There is, however, another side to the story. In a study published in 2009, researchers Harrison Hong and Marcin Kacperczyk made a strong case for doing the exact opposite – investing in so-called "sin" stocks. They argued that there is a "societal norm" against, for example, betting on companies and producers of alcoholic drinks and tobacco. As a result, they showed, such stocks are less likely to appeal to "norm-constrained" institutions such as pension funds. This means their prices are relatively depressed for reasons not related to the success or otherwise of the business and lower prices, of course, mean higher expected returns.

As a result, argues US investment author Larry Swedroe, investors shouldn't leave out the "sin stocks", and are instead better off investing in the whole market, using low-cost index funds. He recently looked at three popular ESG indices managed by MSCI. In each case, the ESG index had underperformed its mainstream peer since launch. What's more, each mainstream index beat its ESG peer while taking slightly less risk.

However, before you pile in to the "vice" stocks you've been shunning, there's something else to be aware of: index providers use different selection criteria for their ESG trackers. Last month, for instance, Ben Leale-Green from S&P Dow Jones Indices compared the performance of the S&P 500 with its ESG equivalent. While the S&P 500 ESG Index does exclude some sin stocks, it takes a more holistic view of sustainability and simply removes stocks with the lowest ESG scores (eg, tobacco and "controversial weapons" are out, but oil giant Exxon Mobil is in). From May 2010 to the end of July 2019, the excess return over the risk-free rate for the S&P 500 ESG Index was very slightly higher than for the S&P 500, while its annualised volatility was also slightly lower. On top of this, three years ago, research by data provider Morningstar concluded that "the idea that sustainable investing is a recipe for underperformance is a myth".

What really matters

Of course, investors should be more sceptical of data provided by companies than by independent academics. And remember that sustainable investing is still relatively new we don't have anything like as much historical data to work on as we do with mainstream investing. That said, the evidence so far suggests that, if there is a performance penalty for sustainable investing, then it's a very small one. And you might, over the long term, receive a modest performance premium. So if you want to use ESG funds, there is no financial reason not to.

However, as with every investment, one thing you do have to focus on is the cost. Simply put, the less you pay, the more you keep for yourself. Active management is a zero-sum game before costs, and a negative-sum game after costs. It's simple arithmetic. So remember that you don't have to use expensive active funds. There are plenty of sustainable funds that are broadly passively managed. So find one that suits your ESG criteria, and don't overpay for the privilege.

Robin Powell is editor of The Evidence-Based Investor (evidenceinvestor.com)