ESG marketing or ESG rating: Which matters more for funds?

Analysis of nearly 5,000 funds shows how popular ESG-marketed funds stack up against high-scoring products

ESG marketing or ESG rating: Which matters more for funds?

As investors and advisors in the investment fund space grow increasingly wary of greenwashing risks and exaggerated ESG claims, it’s no secret there’s a gap between ESG marketing and ESG ratings. But how wide is that gap? And does being ESG-oriented come at the cost of performance?

Those are some of the questions addressed in a recent study by YCharts titled “Is It Easy Being Green?”

Focused on U.S.-listed products, the study dissects a universe of nearly 5,000 funds with at least US$100 million in AUM, including 1,175 ETFs and 3,722 mutual funds.

Within that universe, YCharts identified a group of 158 ESG-marketed funds, distinguished by ESG-related keywords in fund names or investment strategy descriptions. It also divided the original universe of funds into two categories: those with above-average ESG scores based on MSCI ratings relative to their respective broad categories, and those with below-average scores

Among the group of the 25 largest ESG-marketed funds by AUM, YCharts found the best ESG pillar scores, in order, were Environmental, Governance, and Social. On average, those popular funds earned an 8.61 out of 10 ESG rating from MSCI, and scored 0.776 out of 1.000 according to a Comprehensive ESG Fund Score system from YCharts.

But the research also found that the best ESG-scoring funds weren’t necessarily in the ESG-marketed bucket. According to Joe Kleven, a spokesperson from YCharts, 22 of the 25 largest ESG-marketed funds are not among the highest ESG-scoring funds, meaning only three funds appeared on both lists.

“A good amount of the highest-scoring ESG funds don't actually contain any ESG marketing or ‘buzzwords.’ In fact, the highest-scoring ESG fund has only $1.25 billion [US] of AUM,” Kleven says.

“However, the comprehensive ESG score for the fund with the highest AUM [of more than US$21 billion] has a relatively high score of 0.843 out of 1.000, so there are cases where investors aren't missing out on high ESG scores if they do opt for more heavily ESG-marketed funds.”

Among the 25 highest ESG-scoring funds within YCharts’ sample, 13 received perfect 10.0 ratings from MSCI, and only two scored below 0.8 on the YCharts Comprehensive ESG Fund Score metric. On average, the best ESG-scoring funds had overall MSCI ESG scores of 9.91, and comprehensive ESG Fund Score of 0.849.

Across the entire fund universe, the average MSCI ESG score was 7.52, and the average score based on YCharts’ comprehensive ESG scoring was 0.582.

Looking at total returns, Alpha and Beta, Sharpe Ratio, and standard deviation of returns, most popular ESG funds appeared to be superior to those with highest ESG scores on average

Across both lists, most of the best-performing funds were found among the most popular (largest by AUM). Based on three- and five-year lookbacks from August 31, 2022, those funds showed greater returns; they were also down less on a year-to-date and year-over year basis.

Looking at their average Sharpe ratio, the most popular ESG-marketed funds outdid those with the highest ESG scores by 0.21. However, they also showed slightly more volatile performance over a three-year period, with a 25.7% SD compared to 22.3% for the better ESG-scoring funds. Across the list of highest-AUM funds in the research, YCharts saw higher year-to-date, 1-year, 3-year, and 5-year annualized returns compared to the highest ESG-scoring funds.

“ESG funds tend to avoid traditional energy stocks [and/or heavily weight renewable energy stocks], which would have been a drag on performance since the COVID-19 pandemic,” Kleven says.

A greater proportion of high ESG-scoring funds showed positive Alpha; in contrast, the most popular ESG-marketed funds, had a higher average Alpha but also greater variance of scores on the most popular list. Average returns for the most popular ESG-marketed funds were nearly double those of highest-scoring funds.

“When it comes to any given fund's performance, there are certainly factors to consider beyond just a fund's ESG score, such as underlying holdings,” Kleven says, noting that several high-scoring ESG funds are focused heavily on either the semiconductor space or international companies, which have underperformed the S&P over the past 12 months.

Generally, funds with top ESG scores have suffered painful losses in 2022 alongside a broad market decline. As of August 31, S&P 500 was down -15.1% year to date and -11.2% year on year by total return; high-ESG score funds, meanwhile, had -17.7% and -15.4% losses, respectively. But some funds on the high-ESG score list that are doing better than the S&P 500, highlighting the importance of the underlying composition of a fund in its performance.

“With ESG being a relatively new investing concept, it might be too soon to pin the blame on ESG for drops in performance,” Kleven says. “It's best for advisors to know what all is in an ESG investment and to make sure clients understand as well.”