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Survival of the fittest when it comes to ESG fund returns

Scientists in a lab as a metaphor for digging into ESG funds

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.

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. []
{ 16 comments… add one }
  • 1 james November 15, 2021, 10:47 am

    For me,I have been looking st the UBS World Socially Responsible (UC44) etf which seems to be performing well & with a low cost 0.22% and the portfolio is a bit more varied especially after the top 10 (but does have Tesla as largest holding which has helped the return i guess)
    But a quick check on HL shows a completely different top 10 to what anybody else is showing including UBS?

  • 2 cmore November 15, 2021, 11:04 am

    I believe some ESG funds ‘reward’ good practice by oil giants vs their competitors by including them in the fund – might explain some of these unexpected inclusions

  • 3 Jonathan B November 15, 2021, 12:06 pm

    I am sure you are right that natural selection will whittle down the ESG fund options – that has happened for all other themed funds over the years. But will the survivors be the ones with “better” ESG credentials or the ones which are prepared to compromise principles in the hunt for returns?

    There is a huge problem with the lack of consensus as to what ESG really means. There is no ambiguity about listing the top 100 shares by market cap on the London Stock Exchange. There are no such clear criteria that define which listed shares count as ESG, before you worry about which are the top 100 of them.

    To give an example, your L&G and Vanguard tables above both list Apple as their top shareholding. But it is questionable whether a company whose business model depends on the built-in obsolescence of its manufactured products can ever be environmentally sound. And conversely, I suspect some of the big legacy fossil fuel companies now have renewable divisions that easily match some of the niche companies beloved of ESG campaigners; if they are putting themselves in the position to clean up their business over the next several decades could that be worthy of investment?

  • 4 The Scientist November 15, 2021, 12:39 pm

    @Jonathan B

    You hit the nail on the head there. While I strongly want to support ESG as a value, in practice it’s just so challenging. In a way, if you want to be *truly* ESG then you really need to be a naughty active investor.

    It is also fair to say that today’s large energy companies are the best placed in terms of finances, infrastructure and political influence to lead the clean energy transition. I myself do some work with one of these “dirty” energy companies because ultimately I’m a pragmatist and they do have large R&D funds.

    But I also want to keep pushing ESG as an investing concept until something more concrete surfaces.

  • 5 gary November 15, 2021, 1:13 pm

    Hello,
    Off-topic – Have you come across The Venus Project? I am sure it will interest you, and highly recommend you read The Best That Money Can’t Buy.

    This is the next step after FIRE. Working so that everyone achieves freedom from the monetary system. FIRE just for oneself is still limiting.

    https://archive.org/details/bestthatmoneycan0000fres
    https://www.thevenusproject.com/
    https://www.youtube.com/watch?v=Yb5ivvcTvRQ

    Regards
    Gary

  • 6 Andrew Preston November 15, 2021, 1:48 pm

    I generally view the term ‘ESG’ as a minimal definition of ‘green’ or ‘sustainable’ or ‘climate friendly’. Vanguard is absolutely not at the vanguard of any of these. and neither is their ESG Developed World fund mentioned. Nor do they exert any meaningful pressure on companies to change their ways. Basically, Vanguard have been described as greenwashers on this matter.

    I do have some monies invested in that fund. I made the decision because Vanguard I view as brilliant in so many other ways. I am though clear eyed , and constantly review the situation. To that end, I also have monies in the UBS ( UC44 ) ETF which, still, also works to the ‘best in class’ definition of ESG/SRI…, ie there’s an oil company in there somewhere.

    I do not wish to ‘maximise my wealth’ in absolute terms. I look to obtain healthy returns, to do so with a clear conscience, without becoming an active investor.

  • 7 Andrew Preston November 15, 2021, 2:41 pm

    @TheScientist

    Re:… “…. It is also fair to say that today’s large energy companies are the best placed in terms of finances, infrastructure and political influence to lead the clean energy transition. I myself do some work with one of these “dirty” energy companies because ultimately I’m a pragmatist and they do have large R&D funds….”.

    There was a time when, as I recall, that BP was the biggest producer of solar panels in the UK. They made a, er, pragmatic decision to get out of that.

    I disagree profoundly with your specific points, and general premise above.
    In my opinion, where the oil companies are headed is towards where tobacco companies are now. In the process, they’ll go through the stage of what happened with the big computer companies of 30 + years ago….. Burroughs, Univac, Honeywell, IBM, DEC etc. Mergers, consolidations, name changes.

    The political climate is changing rapidly. You talk about ESG, but in reality you’re comfortable where you are. In my opinion.

  • 8 The Investor November 15, 2021, 2:51 pm

    @all — Hi, some good comments already. Just in response to this:

    The political climate is changing rapidly. You talk about ESG, but in reality you’re comfortable where you are. In my opinion.

    Can we focus on the points raised in the article please, and not so much in speculating about individual’s motivations. (i.e. Play the ball not the man).

    I accept @TheScientist brought their own opinions into the picture here, so to that extent it’s fair game. It’s also difficult because ESG ties in so specifically with people’s decisions/ethics/whatnot.

    Still, we’ll generally have a more productive conversation (that’s less likely to become ill-tempered) if we talk about facts and products and guess less about individual poster’s inclinations.

    Thanks!

  • 9 The Scientist November 15, 2021, 3:20 pm

    @AndrewPreston

    I don’t disagree with your points. Big energy companies are guilty of a lot! But if they do go the way of big tobacco, well… tobacco still makes investors plenty of money.

    In terms of investing, I applaud you for having a clear value-based strategy that hopefully has a positive ESG influence. I’m very interested in how others try and make their investing as ESG as they can.

    For transparency, it’s fair to say I’ve diverted most of my ESG guilt by spending my entire career trying to drive positive change in environmental science and climate change research, and have only recently come to investing and thus considering ESG from that perspective.

  • 10 Erico1875 November 16, 2021, 6:25 am
  • 11 xxd09 November 16, 2021, 10:35 am

    We all want to be “good” and do the right thing but the history of active investing versus passive is well proven sadly
    Choosing the ESG option is a active investment choice
    Most probably there will be a serious reduction in the investors portfolio returns if much of the portfolio is composed of these products
    This should be kept in mind
    On the other hand ESG may be the next Apple or Amazon!
    xxd09

  • 12 Jonathan B November 16, 2021, 10:41 am

    @Erico1875, thanks for that thought-provoking link.

  • 13 Raf November 16, 2021, 3:11 pm

    I realize it can be difficult to compare the funds. Interestingly I went through the same exercise previous weekend and compared the ESG Developed World Index to the likes of FTSE Global All Cap Index (which admittedly includes EM) or even Developed World ex-UK. The cumulative performance is similar for YTD: ESG – 18.31 vs All Cap – 16.14 vs Dev World ex-UK – 12.81 with ESG doing pretty well. The 3-year cumulative is 55.56, 49.89 and 43.83 respectively.
    With VEVE achieving 40% and VWRL 37%, there must be something about them like internal structure/rebalancing/transaction costs/currency that makes them perform better? But that would mean comparing the ESG index fund to ETF VEVE would not be fair
    Also, many passive investors using Vanguard index funds would very likely be choosing between say ESG Dev World and Global All Cap one.
    Note: It’s also likely that I am missing something

  • 14 Raf November 16, 2021, 3:29 pm

    I’ve just spotted an error in my comment – I was using YTD vs 1 year (which was used in the post). YTD for VWRL is 16.61 so I guess comparison between ETF and index is fair – I knew I was missing something 🙂

  • 15 LM November 17, 2021, 6:40 am

    If you want a proper and ethical ESG fund, you’re going to be paying through the nose for it, at least in the early days of these things. Nestlé being present in something trying to pass as ethical should be a huge red flag.

    Ethical consumer have done a bit on this subject. Triodos offer 2 funds with high OCF (2%), but are the real deal. IMPAX and WHEB were similar, but fall slightly in some measures I don’t remember since cancelling my subscription. Screening is expensive, unfortunately.

  • 16 Els December 4, 2021, 6:54 pm

    So, am I right that at the moment there is no reasonable no nonsense alternative to life strategy funds which embraces ESG and avoids active management?

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