ESG Passive Funds Fail to Deliver

Passive fund analyst Kenneth Lamont tells Emma Wall how sustainable funds have underperformed thanks to sector biases

Emma Wall 17 August, 2017 | 2:27PM
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Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Morningstar Passive Fund Analyst, Kenneth Lamont, to talk about ESG investing.

Hello, Kenneth.

Kenneth Lamont: Hello, Emma.

Wall: So, the big question is, do investors have to choose between their ESG principles and profit?

Lamont: Well, this is the million-dollar question. This is something I investigated recently in an independent piece. And the answer is, from the records that we have, yes, you do have to sacrifice performance. I should state here that we looked specifically at European-domiciled global equity passive ESG funds. So, this is just one group of funds we've been looking at. But again, the answer is, yes. Yes, you do.

Wall: And it is a large group of funds though, isn't it? That is a lot of data points?

Lamont: It's the largest group of funds that we have and that's why we used that particular dataset. In fact, over 5 years and 10 years not a single fund outperformed the MSCI World on a risk-adjusted basis. Although, we should bear in mind there are no fees involved with the MSCI World and included in the MSCI World Index.

Wall: And what is holding ESG ETFs back in that particular sector?

Lamont: Well, if you look at the ESG funds as a whole, as a sort of homogeneous block, you can see there are structural biases and these are actually quite well-known biases. So, in geographical terms, there is a tilt toward Europe at the expense of the US, which has really dragged on performance over these years. In terms of on a sector level, you see a tilt towards tech stocks which tend to have a very low carbon footprint and away from, as you would imagine, energy or Big Oil and the like.

Wall: So, for investors who are concerned about ESG, who do want to incorporate that kind of screen or positive discrimination into their portfolio, what is the trade-off that they are going to have to make?

Lamont: In the conclusion of the paper we basically said investors are currently faced with two options. There are two broad groups. There are those narrower more ESG-compliant funds, which would work best perhaps for an investor as a part of a wider portfolio. And then those that attempt to be core building blocks and replace your MSCI World or a FTSE 100 exposure. And there's sort of a trade-off between the two of them in terms of performance, the broader, more diversified funds have performed well. But if we look at the narrow funds, depending on the market environment, we may see those funds also outperform. So, it's just those structural differences that need to be taken into consideration.

Wall: Kenneth, thank you very much.

Lamont: Thank you, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar

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