Survival of the fittest when it comes to ESG fund returns

The Scientist from Team Monevator looks into the issue of ESG fund returns. Check back every Monday for more new perspectives from the Team.

Some of the first national parks in the world were established in the U.S. to protect the natural ecosystem.

This conservation effort was inspired by the scientific work of Alexander von Humboldt during his travels in the Americas. There he had discovered unrivaled biodiversity.

Humboldt initially studied finance before moving into the natural sciences.

Given this confluence of interests, if he’s looking down from the great library in the sky Humboldt may be pleased to see today’s prevalence of environmentally conscious investment options.

Another naturalist, Charles Darwin – who was also influenced by Humboldt – posited the theory of natural selection. He proposed the best-adapted species thrive in a given ecosystem.

Given how elaborate and complex the ecosystem of ESG index-tracking products is these days, it hard to see which ones will adapt and which will survive.1

Will it all come down to performance?

Wealth warning: The following analysis looks only at the most recent few years of stock market returns. These years have been kind to ESG funds. We don’t yet have long-term records for this style of investing.

ESG funds haven’t been popular for long enough to do a long-term comparison.

Who knows how well ESG funds will hold up when the market gets ugly?

ESG fund returns matter

Investing is about growing your wealth.

So ESG funds need to make us richer without compromising their self-defined ESG criteria.

Let’s look at a low-cost equity fund that follows the ESG index we dissected in my last post: the FTSE4Good Developed Index.

The L&G PMC Ethical Global Equity Index Fund G25 is a low-cost ESG index fund that has shown continued growth over recent years.

Annualised returns come in at:

• 25.57% over the past year
• 13.11% over the last three years
• 13.80% over the last five years

Ongoing charges are relatively low at 0.25%.

So far you’ve seen your money grow, even with this being an ESG fund.

And you can (potentially) get more peace of mind from knowing that your money is being invested with at least some ethical considerations.

However to my eyes this fund’s ESG credentials are not perfect.

What’s this L&G fund made of?

Here’s how your money is allocated across sectors when you invest with this fund:

ESG comes down to personal beliefs. And in my opinion, I would argue that no company dabbling in oil and gas – representing 2.6% of this fund – is conforming to ESG good practice, given the scale of the climate crisis.

Let’s now look at the companies you own by investing in this fund:

Although they’re good enough for the rather bloated FTSE4Good algorithm, for my money none of the companies in the L&G funds’ top ten holdings are synonymous with especially great ESG behaviour.

ESG fund returns versus non-ESG funds

How do low-cost ESG and non-ESG funds compare directly?

This is a trickier question to answer because similar-sounding funds may not be directly comparable under the hood.

But I think we can get pretty close by comparing two funds run by everyone’s (passive) investment darling, Vanguard.

• One fund is ESG-friendly: Vanguard ESG Developed World All Cap Equity Index Fund.

• The other is not: Vanguard FTSE Developed World UCITS ETF (VEVE).

The two funds both aim to track global developed world equity indices, however. So they should offer fairly comparable returns.

Here’s how the fund returns compare:

• The ESG fund returned 31.7% over the past year versus 40.0% for the non-ESG fund.

• It delivered 16.4% compared to 19.0% annualised over the past three years.

• Over the past five years the ESG chalked up annualised returns of of 13.2% verus 16.2% for the vanilla index.

Ongoing charges were low for both, although the ESG fund is slightly higher at 0.20% compared to 0.12% for the non-ESG fund.

What is responsible for these differing returns?

The composition of these two funds is very similar:

If you dive into the list of companies held in each fund, it’s not until the 28th listed holding that you get to something overtly non-ESG. There you’ll find Exxon Mobil Corp comprises 0.41% of holdings in the non-ESG fund.

At the same place in the list in the ESG fund you have Thermo Fisher Scientific Inc, an American supplier of scientific equipment and materials. That is down at 31st in the non-ESG fund.

So while the largest holdings in the funds appear very similar, there are some clearly non-ESG companies in the standard index fund.

And as we saw in those annual returns above, it seems that by excluding such firms you lose some performance. Albeit only a few percent over the long-term.

That said, in the fairly abnormal year just past the non-ESG fund outperformed by almost 9%. That sort of gap would really compound horribly if it continued over time.

ESG fund returns versus Active fund options

ESG considerations are not specific to low-cost index funds.

Active funds are cashing in on the trend as well.

Fundsmith Equity Fund is a popular actively managed fund, having performed well over the past decade.

And now it has a sustainable option too, operating since mid-2016.

The sustainable vs. non-sustainable funds have performed very similarly: 24.3% vs. 25.9% for the past year and 21.2% vs. 22.4% annualised over the past three years.

For context, the longer running non-sustainable fund has delivered 24.8% annualised over the past five years. We have a little while longer to wait for five-year returns from the ESG-friendly offering.

Active management comes at a cost. Ongoing charges are 0.96-0.97% (the sustainable fund is 0.01% more expensive).

Interestingly, the differences in composition of these two funds are more noticeable than with the passive options above:

The non-sustainable Fundsmith offering contains a big whack of tobacco, mostly in the form of Philip Morris International Inc.

But tobacco is the standout ‘bad guy’ here. Other popular sin stock sectors like Oil & Gas do not seem to feature.

Indeed, to me it’s not clear if the holdings within the different sectors are notably more ‘sustainable’ in one fund over the other.

This matters because so far there’s been a (small) sacrifice in performance of a few percent from choosing Fundsmith’s sustainable option.

As an ESG investor you don’t want to under-perform for no good reason.

Who will survive?

For ESG funds to stay popular, they need to achieve good growth in absolute terms, whilst not being smoked by non-ESG funds on a relative basis.

The ESG options I’ve looked at in this aticle are short a few percent points of performance versus their non-ESG comparisons.

Such deficits are not so bad when annualised growth is consistently in the double figures anyway. But how long will that last?

And any deficits will compound over time.

ESG ideologies are surely here to stay. But specifc funds will come and go.

It is up to each individual investor to decide which ESG options work for them. Those funds will only survive if you and other investors back them.

And survival will depend on whether the funds perform – or else on whether their managers can convince customers that any performance loss is justified by the effectiveness of their ESG criteria.

Your move

Judging by the comments on my last post, there are a lot of different views on how to be ESG-responsible with your money.

Choosing ESG investment options can at least indicate to the market that consumers want ESG products.

And non-selective global funds will eventually evolve to incorporate ESG trends anyway, if that’s the direction society as a whole is moving.

But the ball needs to keep rolling for societally-relevant ESG trends to make it into general index trackers.

For that to happen, there must be continued investment through ESG strategies to signal that this is the direction people want to go in.

It’s up to you if that’s something you’re willing to pursue – and if you’re willing to put your money on the line!

I won’t judge you either way.

But for myself, I’m willing to sacrifice a few points of performance in the hope that there’s something left of our natural world for the next generation.

(I said a few percentage points, mind…)

You can see all The Scientist’s articles in their dedicated archive.

1. ESG funds are managed with Environmental, Social, and Governance criteria in mind. [↩]