When creating a fund, fund managers must choose how to allocate their assets among the sectors of the economy. They must also choose which companies will represent those sectors, and how to distribute the asset allocation among the companies that represent each sector.
- Deciding on how and where to allocate funds is a critical skill in fund management.
- The Brinson–Fachler (BF) model was used to determine the source of the returns, sector allocation, stock selection, or a mix. We took this model and applied as an example to ESG index funds.
- Analysis using data from Refinitiv Eikon showed that ESG index funds yielded higher returns by allocating assets in thriving sectors, such as information technology, and avoiding sectors that are doing less well, such as energy.
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Index funds are designed to track specific indexes, such as the Dow Jones or S&P 500. They are among the most popular investments by investors, including retirement savers.
ESG index funds incorporate data points relating to a company’s ESG profile as well as traditional financial metrics to screen and weight securities. Most current ESG funds were launched in 2013-2014, when the approach was gaining momentum.
The COVID-19 market crash, the worst single-day drop since 1987, is the first major test of these funds’ resilience.
This test is being taken just as new regulations aim to limit investment in ESG funds. In June, the U.S. Department of Labor proposed amendments to make it more difficult for retirement plans regulated under the Employee Retirement Income Security Act (ERISA), including 401k plans, to include ESG funds.
The Labor Department suggested that ESG investing may prioritize environmental or social causes over financial return, the top priority of retirement plans. Ironically, the Labor Department’s proposed rule was published at a time when most ESG index funds have outperformed conventional funds with 24 of 26 ESG index funds covering both U.S. and global stocks outperforming the comparable conventional funds.
The factors behind recent outperformance
We analyzed the 10 largest U.S. open-ended ESG index mutual funds and exchange-traded funds (ETFs) because ESG index funds are usually cheaper than actively managed ESG funds and are more likely to be included in retirement plans.
We took the Vanguard S&P 500 ETF (ticker: VOO), a highly rated U.S. Large Blend ETF that tracks the S&P 500 Index — with the lowest expense and tracking error among peers — as our benchmark.
We used the popular, simple Brinson–Fachler (BF) model to determine the source of the return difference between ESG index funds and the benchmark — sector allocation, stock selection, or a mix. (While the BF model is often used to analyze actively managed funds, ESG index funds can be considered quasi-active because they use additional rules to select and weigh stocks differently than a pure market-cap weighted index fund.)
Performance of U.S. equities vs U.S. ESG funds 1H20
The ESG funds in our analysis outperformed VOO by an average of 2.1 percentage points, net of expenses (that is, after fees).
To put this in more concrete terms, an investor who divided $1 million evenly among the top 10 ESG index funds instead of VOO in January 2020 would have had $17,000 more in June.
The allocation effect
The allocation effect determined by the BF model refers to the difference in returns caused by the fund having different sector weights than the benchmark.
Others have also attributed the outperformance of ESG funds in 2020 to their lower exposure to the year’s worst-performing sector — energy, and higher exposure to the best-performing sector — IT.
Robert Jenkins, Head of Refinitiv Lipper Research, concludes in his research report that a likely reason for all this tech is simple: These companies tend to not be known as carbon-intensive emitters, and therefore seem like safe bets to front up an ESG portfolio.
He adds that it doesn’t hurt that these same stocks have been on a years-long bull run, and that they are thoroughly outpacing market averages and most typical stocks. Microsoft is up more than 300 percent in the past five years, and Amazon has increased more than five-fold during the same period.
In terms of other sector coverage, Jenkins observes that one sector the active managers have clearly been actively banishing from their portfolios over the past few years is all things energy.
Stock selection strategies for ESG Funds
Within the BF model, selection effect refers to the value added (or lost) by the fund investing more or less in particular individual stocks within the sector compared to the benchmark.
Stock selection contributed an average of 0.65 percentage points for these 10 ESG index funds. In other words, ESG index funds not only benefited from avoiding energy and investing in IT stocks, they also did better by picking good stocks within sectors, too.
DFSIX is an outlier because it performed worse than VOO and its peer ESG funds. This could be because it had the greatest exposure to smaller companies, which are more vulnerable to the COVID-19 pandemic than larger ones. However, some other funds (TISCX and ESGV) also have exposure to small stocks and did well. Consequently, DFSIX’s underperformance requires future investigation.
Although most funds had positive selection effects on average, they varied greatly across sectors.
The average positive stock selection effects were highest in financials, health care and industrials, while the average negative stock selection effects were highest in energy and consumer discretionary sectors. This could be due to factors beyond the funds themselves, as most funds track ESG indices provided by third-party index sponsors.
Outperformance of large ESG index funds
Although our analysis covered a short period of time, the consistent outperformance of most large ESG index funds from both sector allocation and stock selection during the COVID-19 pandemic illustrates that ESG index investing does not necessarily harm returns. In fact, ESG index funds may help investors manage downside risk better than traditional index funds.
This recent outperformance only adds to existing evidence in favor of ESG investment strategies.
In light of this, the proposed rule by the U.S. Labor Department to increase the administrative, financial, and legal burden to include ESG funds in retirement plans could hurt retirement investors by limiting their access to important and potentially better investment options.