Key Points:
- Investors expect ESG funds to outperform their alternatives on ESG criteria.
- ESG funds have grown into a $400 billion market in the US.
- ESG funds typically have marginally higher ESG scores than their parent market indexes.
- Investors pay 40% higher fees on average for sustainable funds.
When investors purchase environmental, social, and governance (ESG) equity index funds, they generally expect the funds to achieve higher ESG ratings compared to other investment options. After all, ESG is included in the name of these funds, implying that they consider ESG factors in their investment decisions. However, whether ESG funds actually deliver better ESG scores is not just a theoretical question. In the United States alone, ESG funds, including both mutual funds and exchange-traded funds (ETFs), have become a $400 billion market.
In order to test whether ESG funds achieve higher ESG scores, it is necessary to determine what to compare them against. Many ESG funds track ESG indexes provided by third-party index creators such as MSCI and S&P. For example, the SPDR S&P 500 ESG ETF, managed by State Street, aims to correspond to the S&P 500 ESG Index. The S&P 500 ESG Index is designed to measure the performance of securities meeting sustainability criteria while maintaining industry group weights similar to the S&P 500.
Since the SPDR S&P 500 ESG ETF tracks an ESG index, it is important to consider whether the ESG index has a higher ESG score than the benchmark S&P 500. To approximate the ESG scores of these funds, the top 10 holdings of each index were manually evaluated using publicly available ESG ratings from MSCI and Sustainalytics. The average of the two agencies’ ratings revealed that the S&P 500 ESG Index had a cap-weighted ESG score 6.0% higher than the S&P 500.
A similar exercise was conducted with 19 other popular ESG indexes, comparing their ESG scores to their parent market indexes. While there was a wide range of variation in the results, with some ESG indexes showing lower ESG scores than their parent indexes, the majority showed only marginal improvement in ESG scores. The average improvement was 8.3%.
In light of these findings, investors may need to reconsider their expectations regarding the relationship between fees and ESG scores. On average, sustainable funds have 40% higher fees compared to non-ESG funds. However, higher fees do not necessarily translate into significantly higher ESG scores.
In conclusion, while ESG funds generally have slightly higher ESG scores than their parent market indexes, the difference is not significant. Investors need to be aware of this when considering the higher fees associated with sustainable funds.
