Treating industry returns as a possible factor in explaining environmental, social, and governance (ESG) fund returns, we find that only a few industries have had a statistically significant impact on fund returns, both before and after controlling for style factors. What’s more, we find substantial variations in industry allocations among individual ESG funds, so investors are best served by assessing them on a fund-by-fund basis.
As ESG investment products continue to grow in popularity, investors may be curious about what drives the performance of ESG funds relative to the performance of the broader market.
Can the growing number of investors considering these products find any discernible patterns in performance?
To help answer this question, we investigated whether returns are driven by over- and underweights of industries in ESG equity index funds compared with the weightings in the broader equity market. We looked at equity index funds and ETFs with a U.S. investment focus that indicated that ESG factors were used in their investment process, according to Morningstar, Inc., from January 1, 2006, through December 31, 2020.
Our previous research, based on a similar range of ESG funds, found that the performance of many of the funds deviated from that of the broader market and that part of the performance difference could be explained by exposures to style factors.1 What we did not explore in that study was the role of industry allocations.
Many ESG funds under- or overweight companies based on their business activities, such as tobacco production or oil and gas extraction or distribution. ESG funds that apply an exclusionary screening approach explicitly (and often solely) focus on such business activities. As a result, these funds should have industry allocations that differ systematically from those of the broader market.
Funds that apply inclusionary approaches, which often select companies by assessing their exposure to ESG risks, also tend to have different industry allocations than their non-ESG peers because ESG risks are often industry-specific.