Those interested in the space should carefully consider the costs of responsible investing
Increased investor interest in ESG has been one of the more significant stories of 2019, with millennials and institutional investors among the staunchest advocates; despite this, advisors don’t appear to be prioritizing ESG exposure for their clients’ portfolios. And as new commentary from FactorResearch suggests, they may be right.
“Two investor types that are particularly keen on ESG investing are public pension funds and Millennials,” wrote managing director Nicolas Rabener. “However, there is a case to be made that neither of these should consider ESG investing.”
Rabener outlined some concerns with ESG investing approaches, some of which run parallel to criticisms previously levelled by others. Aside from additional costs of ESG products and ESG data issues, he stressed that ESG-based portfolios can be less diversified as the strategies exclude low-ranking companies or tend to result in sector biases.
“Specifically, this results in a structural overweight in technology and underweight in energy stocks,” he said, sharing the result of an analysis of ESG ETFs in the US. “Technology stocks have fallen out of favor before while energy stocks tend to benefit from geopolitical tensions that increase the oil price.”
He also showed a performance analysis of ESG ETFs stretching back to 2005, which provided a full market-cycle picture of how ESG ETFs fared against the S&P 500 and Russell 3000. Based on that assessment, an equal-weighted index of ESG ETFs would have slightly performed either benchmark since 2005.
Going a step further, he showed that using different starting points — comparing ESG ETFs’ performance with the Russell 3000 and S&P 500 since 2006, since 2007, and so on — changes the outcome randomly, with US-listed ESG ETFs outperforming in some cases and underperforming in others. “ESG investing certainly does not generate consistent outperformance,” he said.
That lack of consistent outperformance is concerning as pension funds around the world, both public and private, face funding challenges. Given low funding ratios along with the current low interest-rate environment, the notion that future retirees will have to accept haircuts on their pensions — and possibly lower living standards or poverty — is uncomfortably easy to imagine.
“The only real obligation that pension funds have is to meet their liabilities and pay full pensions to retired workers,” Rabener said. “With regards to ESG investing there is only one question that is relevant for the investment officers at pension funds: How sure are you that ESG investing will not cost performance?”
Millennials are in similarly poor financial shape, he added. While some stand to benefit from an oncoming wave of wealth transfers, the majority have fewer assets and carry more debt than previous generations had at their age, due in part to rising costs of education and homeownership.
“It is therefore questionable if Millennials should take the risk of potentially lower equity returns on their investment portfolios,” Rabener said. “New research on ESG investing is published almost daily … Albeit much of that research is from product providers, which should be viewed with skepticism given clear conflicts of interests.”