A deeper look into how to make sustainable investing possible through the use of passive funds
Sustainable investing has become a hot topic as more and more investors are looking to align their investments with their values.
The market share of European equity funds that consider environmental, social and governance factors has almost doubled to 9 per cent from barely 5 per cent three years ago, and the growth outlook remains positive.
Sustainable investing has traditionally been the preserve of active managers. But passive strategies too can incorporate ESG criteria. Improved ESG data on companies and technological advancements in indexing have made new approaches to passive sustainable investing possible.
The growing flows into passive ESG funds show that for an increasing number of investors, taking a stance in favour of sustainability should not be at odds with enjoying the advantages offered by passive funds; mainly their low cost and transparency.
What about performance? To find out, we compared the returns of passive ESG funds with active ESG funds, as well as passive conventional funds in three major Morningstar equity categories, namely Europe large-cap blend, US large-cap blend and emerging markets large-cap. The results are shown in the table below.
Confirming multiple studies showing that ESG considerations do not hurt portfolio returns, we found that both active and passive ESG funds have on average done much better than category peers over three, five and 10 years.
Within the categories, passive ESG funds have beaten active ESG funds. This is due in part to their very low cost. Passive ESG funds are on average three times cheaper than active alternatives.
Additionally, passive ESG funds have outperformed their plain vanilla passive counterparts in the Europe and emerging markets large-cap blend categories, although not in the US large-cap blend category.
While the outperformance of European passive ESG funds relative to conventional passive options is small (0.11 per cent), in emerging markets it is much more significant (0.58 per cent). Apart from fees, the small difference in performance between ESG and non-ESG passive funds in the Europe equity category can be explained by the fact that Europe is the world’s leading region for sustainability.
Many European companies with high ESG scores end up in ESG portfolios, as well as conventional ones.
The story is quite different in emerging markets, where ESG standards are typically lower. Fewer companies in the space receive high ESG scores. And focusing on these companies has proven to be a winning strategy.
By contrast, taking an ESG approach to US large-cap equity has not paid off. Over the past three and five years, passive ESG funds have lagged their plain vanilla passive equivalents by 0.18 per cent and 0.33 per cent per year, respectively.
This underperformance can be largely attributed to US technology companies. Many ESG passive funds in the Morningstar US large-cap blend category have been underweight Apple, Amazon and Facebook due to their below-average ESG scores. These three stocks have enjoyed stellar returns. Still, over 10 years, ESG passive funds have done slightly better (0.07 per cent) relative to conventional passive funds.
With that being said, it is important to be aware that significant differences exist across passive ESG strategies, which can lead to differences in returns. Here are two example emerging market funds with contrasting performances.
NT Emerging Markets Custom ESG Equity Index fund
The fund aims to replicate the MSCI Emerging Markets index but excludes companies that do not meet certain socially responsible principles. It excludes those that are involved in very severe controversies, companies involved in the tobacco industry and controversial weapons, and businesses that do not meet certain governance criteria.
Despite a middle-of-the-road ongoing charge of 0.35 per cent, the fund has beaten all the cheapest exchange-traded funds tracking the MSCI Emerging Markets index, generating an annualised return of 11.44 per cent over the past three years.
UBS MSCI Emerging Markets
Meanwhile, the more expensive UBS MSCI EM SRI ETF (ongoing charge: 0.53 per cent) has returned only 8.69 per cent a year over the past three years.
By targeting the top 25 per cent of emerging market companies ranked on ESG scores per sector, the fund is underweight in its exposure to China and Russia.
The largest deviation is in China, which comprises close to 30 per cent of the MSCI Emerging Markets index, but only represents 3 per cent to 5 per cent of the total weight in the SRI portfolio.
China and Russia trail behind their peers across ESG factors but have outperformed in recent years.
Hortense Bioy is director of passive strategies and sustainability research at Morningstar Europe