The performance of exchange-traded funds (ETF) with environmental, social and governance (ESG) criteria may vary widely due to the different sustainability goals they support, research conducted by a global index provider has shown.
A report from research firm Scientific Beta, titled “From ESG Confusion to Return Dispersion”, examined 34 sustainability-focused ETFs with ESG components invested in United States equities and found a 6.9 per cent difference in annual returns between the best and worst-performing funds. However, this could extend to a maximum disparity of 22.5 per cent over a single calendar year when adjusted for market exposure.
Scientific Beta research director Felix Goltz pointed out this difference could be attributed to the varying sustainability metrics these funds follow and the lack of a comprehensive standard for ESG investing.
“ESG fund returns largely depend on fund-specific choices of how to integrate ESG information. This suggests that ESG investors face substantial fund selection risk,” Goltz noted.
“Importantly, traditional fund selection strategies such as relying on past performance or tracking error are inadequate for predicting future ESG fund performance.
“Our evidence emphasises that inconsistencies in ESG approaches contribute to significant dispersion in the performance of ESG investment products.”
He warned some providers may be mining data they could use to give an exaggerated and misleading view of how the strategy may perform in the future.
“Dispersion in performance allows ETF providers to always present investors some strategy that has recently outperformed. The evidence from the literature on funds’ flows suggests that investors are particularly sensitive to recent performance,” he explained.
“This issue is aggravated by the fact that there is no consensus on the definition of ESG, which gives ETF providers a licence to come up with new products that replicate ESG approaches that have recently outperformed.”
According to Goltz developing a uniform approach to what should be included in the ESG component of a fund should be viewed as a positive step for the investment community.
“It remains to be seen whether the industry will move towards harmonisation of ESG definitions and practices, a shift that would reduce divergence and ultimately returns dispersion,” he observed.
“Our empirical results suggest that the current confusion of ESG practices translates into return dispersion that in turn creates risk for those investors who select among different ESG investing products. In other words, fund selection risk is a material ESG issue.”
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