Why investors shouldn't compare ESG fund apples to broad index oranges

Study suggests evaluating fund managers to a benchmark with more green stocks leads to better outcomes

Why investors shouldn't compare ESG fund apples to broad index oranges

ESG investors must measure fund managers by a yardstick other than the usual broad-market equity benchmarks in order to effectively pursue their objectives.

That’s according to a new working paper from the Centre for Economic Policy Research, where researchers argue that evaluating ESG funds against a staple index like the S&P 500 imposes constraints that cause middling ESG scores among fund managers while hurting their returns.

As explained in Institutional Investor, the thinking goes that current incentive-based contracts that reward asset managers based on their performance compared to benchmarks leads them to crowd into the same kind of assets. That, in turn, pushes up prices and leads to lower expected returns.

“Contracts incentivize the managers to invest more in stocks with higher alpha as well as stocks in the benchmark,” said the authors in the paper. “This boosts prices and lowers returns, making the marginal benefit of alpha-production lower for everyone.”

To dissipate that crowding effect, the researchers proposed the use of a “socially optimal contract,” which would provide a level of benchmarking that’s optimized for all of society. Mechanically, that would involve providing for less incentives and less benchmarking within an individual contract.

“The social planner, who internalizes the effects of contracts on equilibrium prices, opts for less incentive provision, less benchmarking, and lower asset management costs,” they said.

In the context of ESG investing, they argued that while current industry benchmarking conventions result in portfolios with average ESG scores, ESG-centred benchmarks would be more useful in coaxing managers to take a more sustainable and responsible direction.

“The manager should be benchmarked to an ESG benchmark that will tilt overweight green stocks and underweight browns,” Natalia Kovrijnykh, one of the study’s authors, told Institutional Investor. “But, then we looked at how this is done in practice, and there is only a handful of ESG benchmarks. … They’re very, very small relative to the huge industry that ESG is becoming.”


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