With the rise and rise of ESG investment funds over the past few years, the question of whether they perform better or worse than standard passive funds has been the subject of much speculation and debate. 

A new report from Morningstar has sought to settle questions and the good news is, despite relatively limited data because they are  a fairly new phenomena, on average ESG funds don’t perform any worse than standard funds. 

Tim Murphy

Report author and director of manager research, Tim Murphy told The Fifth Estate the important takeaway for fund managers was that it is possible to build a portfolio that aligns with client values on ESG, without sacrificing returns. 

“I’d say with any investment community there’s an expectation that ESG funds, certainly over the long term, may underperform because you’re narrowing your opportunities,” Mr Murphy said. 

“What we wanted to do was just test that empirically, and obviously there’s a range of approaches, but the conclusion on average was they were no better, but no worse either.”

Morninhstar’s research focused on Australian-domiciled global equity funds, which contained the largest sample size of ESG funds available for Australian investors and provided the broadest possible investable universe of any asset class.

Of 33 funds of this type in Australia, only 19 had three-year track record to compare and just 14 had a five year record. 

A five year risk/reward comparison showed none of the funds falling in the most desirable top-left quadrant of higher return with lower risk, “where every investor aims to be.”

The five-year return and standard deviation of each fund compared and plotted with the commonly used index for the asset class, MSCI World ex Australia, as the crosshair. Source: Morningstar

However, over the most recent three years, seven funds achieved higher returns with lower risk than the MSCI Index, six funds had higher returns with higher risk, four funds delivered lower returns with lower risk and just two funds had lower returns and higher risk.

Table

While ESG funds have a reputation for being less risky, based on average performance in recent years, they were no less risky than traditional investments, including in fossil fuels. 

He made clear that this was only a reflection of past performance, which over the past 18 months had been mixed. 

“Certainly in 2020 a lot of types of the investments that ESG favours did quite well — but this year the reverse of that is true. We’re seeing record high coal prices at the moment for instance,” he said. 

As far as long term risk to investments in industries such as fossil fuels goes, Mr Murphy explained the report was not making a judgment either way. “We were only looking at what has been the riskiness of the performance profile of these funds to date,” he said. 

The Australian Prudential Regulatory Authority, however, is in the process of developing guidance for institutions and fund managers directly geared to handling the future risk of climate change to investments. 

Ethical investments surge as climate change does the same

He added one of the purposes of the paper was to point out the range of different approaches to ESG investing that were falling into the same basket, and the trap that posed for potential investors. 

“If you’ve got 20 funds that all say ‘we’re XYZ sustainable global equity fund’ on the lid, obviously under the hood there’s a wide range of different approaches and different ways of defining and going about that,” he said.

While there are tighter regulations on what can constitute an ESG fund in Europe, and plans for better consistency around the world, Murphy said it would remain important for investors to look beyond the label and apply their own ESG values in selecting where to put their money.

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