Lack of Track Records Hinder ESG Investing

Additional conclusive information about environmental, social and governance (ESG) investment performance may help retirement plan sponsors be less wary about making ESG investment decisions.

A study by Natixis Investment Managers finds 56% of institutional investors believe there is alpha to be found in environmental, social and governance (ESG) investing, but lack of track records and difficulty measuring performance are cited as main challenges.

Despite positive perceptions and growing demand for investments that reflect their values, Natixis found that investors are not blindly accepting when it comes to ESG investments. Many want more information to support their ESG investment decisions. Only 47% of investors globally, and 50% of those in the U.S., say they have the information they need to make socially responsible investment decisions.

Past research has suggested that ESG investments are an opportunity to enhance long-term, risk-adjusted investment performance. However, recent research by California-based think tank, the Pacific Research Institute (PRI), analyzing 18 funds with a 10-year track record, concludes that a $10,000 ESG portfolio would be 43.9% smaller compared to an investment in a broader, S&P 500 index fund. Just one fund would beat the earnings of an S&P 500 investment over five years, and just two would beat it over a 10-year period.

Dr. Wayne Winegarden, PRI senior fellow in Business and Economics and the study’s author, noted the funds also carried higher risks than S&P 500 funds because they are less diversified in their holdings. Thirty-seven percent of funds are allocated to the top 10 holdings on average in ESG funds Winegarden studied, compared to 21% in a broader S&P 500 index fund.

This lack of certainty about ESG performance is one factor hindering greater adoption of ESG investments in Employee Retirement Income Security Act (ERISA) retirement plans, the Government Accountability Office (GAO) suggested in a report last year. The GAO noted that while finding that incorporating ESG factors has a positive or neutral impact on financial performance, the perception that it could negatively impact performance persists. Yet another problem asset managers told the GAO about is that incorporating ESG factors in investment management may increase costs to retirement plans because of the additional resources needed to assess the ESG factors.

Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management (NTAM), recently told PLANSPONSOR, in his opinion, ESG is an independent source of risk that must be addressed. “Consider what happened with Volkswagen’s stock when the emissions cheating scandal came out. That is bad governance and it is absolutely a source of material risk today that will impact your portfolio, if ignored. So if you can measure governance, and you can control the risk around governance, that’s enough for me to say that ESG is a factor that should be addressed during portfolio construction,” he said.

However, Hunstad said it is equally important to ask whether an investor will see excess returns for going overweight in ESG-conscious stocks. “We have to be careful in this analysis,” Hunstad suggests. “I like to say that the best case for higher performance of ESG stocks is over the long-term.”

In “Sustainable Investing in Defined Contribution Plans: A Guide for Plan Sponsors,” the Defined Contribution Institutional Investment Association (DCIIA) says a baseline knowledge of ESG factors can lead to a more in-depth dialogue with investment managers, plan consultants and advisers. “All relevant investment characteristics must be considered and evaluated, with the help of a plan adviser or consultant,” the report says.