Scientific Beta

Investors increasingly incorporate ESG criteria into their investment strategies. However, defining sustainability and identifying material ESG issues remain contentious. The absence of clear standards has led to a large disparity of metrics, a phenomenon commonly referred to as ESG confusion. Investors interested in sustainable investing strategies must assess whether such confusion has an impact on financial performance. In this paper, we address this question by examining the performance dispersion in the cross-section of a set of ESG funds invested in US stocks. 

Investors increasingly incorporate Environmental, Social, and Governance (ESG) criteria – also known as sustainability criteria – into their investment strategies. However, defining sustainability and identifying material ESG issues remain contentious. The absence of clear standards has led to a large disparity of metrics, a phenomenon commonly referred to as ESG confusion.

Investors interested in sustainable investing strategies must assess whether such confusion has an impact on financial performance. We address this question by examining the performance dispersion in the cross-section of a set of ESG funds invested in the US stocks. Our findings reveal substantial performance disparities in the cross-section of these ESG funds. Over a six-year period, the difference in annualised returns between the best and worst ESG funds is 6.5% when adjusting for differences in market exposure. When removing effects due to differences in industry exposure, the difference remains high with 4.9%. Over single years, the dispersion can be even more dramatic, reaching a maximum of 22.5% in terms of returns adjusted for market exposures, and 25.3% in terms of industry-adjusted returns. This large dispersion shows that fund returns are not mainly driven by a common sustainability factor. Instead, fund returns largely depend on fund specific choices of how to integrate ESG information. This suggests that ESG investors face substantial fund selection risk. Importantly, traditional fund selection strategies like relying on past performance or tracking error are inadequate for predicting future ESG fund performance.

In conclusion, our evidence emphasises that inconsistencies in ESG approaches contribute to significant cross-sectional dispersion in the performance of ESG investment products. Investors need to be aware that fund selection risk is a material issue for sustainable investment strategies.