I’ve been what you might call a socially irresponsible investor all of my life.
Perhaps the time has come to reevaluate my strategy by taking a look at the hot space of environmental, social and governance (ESG) investing. By buying broad index funds, I know I have many companies that fail on every ESG screen. So I decided to get educated and see if I should change my strategy.
I began my education by attending the SRI 30 Conference that happened to be in my hometown of Colorado Springs last month. Conference organizers said it was a record turnout. An even better indicator is that investors are voting with their wallets.
Jon Hale, head of sustainability research at Morningstar, reported cash inflows this year through September of nearly $13.5 billion, which is on pace to triple inflows from last year. Hale told me it was a myth that ESG investing leads to lower returns.
Higher fees lead to lower returns, but there are now 91 ESG ETFs with annual expense ratios as low as 0.10%. Of that total, 25 have expense ratios of 0.20% or less. Nearly everyone at the conference told me their primary goal for ESG screens was to improve investment performance. “Poorly governed companies tend to underperform,” stated one attendee.
Being the skeptical person that I am, my immediate hypothesis was that ESG performed well over the past several years because those funds excluded energy companies, which seemingly would fail the environmental screen. Those oil and gas companies badly underperformed.
I hate it when facts get in the way of my theories, as a recent Wall Street Journal article reported that eight of the 10 largest ESG funds are owned energy companies.
Is there a performance penalty to be socially conscious? Morningstar’s Hale says no, pointing out his study that indicates ESG funds performed very similarly to other mutual funds, using the Morningstar five-star past performance scale between 2002 and 2016. He also notes the largest of all ESG funds, the iShares MSCI KLD 400 Social ETF (DSI), outperformed the S&P 500 since its inception.
Curiously, however, Morningstar benchmarks the fund against the Russell 1000 and shows a 10-year underperformance of 0.91 percentage points a year for the past decade ending Nov. 22, 2019. Morningstar gives it a so-so bronze forward-looking rating. By contrast, a total stock ETF such as the Vanguard Total Stock Market ETF (VTI) earned an extra 0.81 percentage points annually and has a gold forward-looking rating.
A separate and more recent Morningstar study of 56 unique screened ESG indexes generally outperformed in Asia and Europe, but had “ambiguous” results in the U.S. On the other hand, Robert Huebscher, founder and CEO of Advisor Perspectives, notes a study by the Pacific Research Institute of the 18 funds with a 10-year track record had significant shortfalls versus the total return of the S&P 500.
Even a 10-year study is far too short upon which to draw any conclusions. I admit that I’d love to outperform the market as many ESG proponents claim. In fact, I’d love to say I’m a responsible investor and even getting market returns, but the arithmetic behind higher fees points to lower probabilities of getting those market returns. In addition, higher concentration of holdings versus total index funds leads to a bit more risk.
So while I’m thrilled that there are now low-cost ways to own ESG funds, I’m not jumping in yet. Part of the reason is that the ESG space is hot, and I make it a rule to avoid any hot part of the market. This reminds me a bit of “smart beta” several years ago, with promises of outperformance without additional risk. As money poured in, I noted how smart beta was dumb and, predictably, it turned icy cold, badly underperforming.
I’m going to continue to buy the broadest of the index funds at the lowest costs, which I know will include stocks bad for the environment, not promoting worthwhile social causes, and poorly governed companies. I’ll do what I’ve been telling clients to do for well over a decade: Own the entire market and take the cost savings and give to the causes you believe in.
My decision may not be yours so, if you do some ESG investing, keep your costs low.
(Author’s note: I also write for Advisor Perspectives, referenced in this piece.)
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.