A new study from Scientific Beta, “From ESG Confusion to Return Dispersion: Fund Selection Risk is a Material Issue for ESG Investors”, examines the performance dispersion of ESG funds and finds that fund selection risk is a material issue for sustainable investment strategies, creating the possibility of data mining.
The findings show substantial performance disparities between a set of ESG exchange traded funds (ETFs) invested in US stocks. In particular:
- Over a six-year period, the difference in annualised returns between the best and worst ESG funds is 6.5%when adjusting for differences in market exposure.
- When removing effects due to differences in industry exposure, the difference remains high at 4.9%.
- Over single years, the dispersion can be even more dramatic, reaching a maximum of 22.5% in terms of returns adjusted for market exposures, and 25.3% in terms of industry-adjusted returns.
Commenting on the study, Felix Goltz, co-author, and Research Director at Scientific Beta, said, “ESG fund returns largely depend on fund-specific choices of how to integrate ESG information. This suggests that ESG investors face substantial fund selection risk. Importantly, traditional fund selection strategies like relying on past performance or tracking error are inadequate for predicting future ESG fund performance.
“Our evidence emphasises that inconsistencies in ESG approaches contribute to significant dispersion in the performance of ESG investment products. Investors need to be aware that fund selection risk is a material issue for sustainable investment strategies.”
An important aspect of fund selection risk is that the large dispersion in performance also creates the possibility of data mining by product providers.
“Dispersion in performance allows ETF providers to always present investors some strategy that has recently outperformed. The evidence from the literature on funds’ flows suggests that investors are particularly sensitive to recent performance,” Mr Goltz said.
“This issue is aggravated by the fact that there is no consensus on the definition of ESG, which gives ETF providers a license to come up with new products that replicate ESG approaches that have recently outperformed. It remains to be seen whether the industry will move towards harmonisation of ESG definitions and practices, a shift that would reduce divergence and ultimately returns dispersion.
“Our empirical results suggest that the current confusion of ESG practices translates into return dispersion that in turn creates risk for those investors who select among different ESG investing products. In other words, fund selection risk is a material ESG issue.”
The Scientific Beta study can be accessed here:
About Scientific Beta
Scientific Beta is a global provider of advanced index solutions designed to help asset managers and institutions understand and invest in smart factor and ESG equity strategies. Established by a leading fundamental and applied investment research institution, the EDHEC-Risk Institute, Scientific Beta incorporates an academic level of scientific rigor and veracity into its solutions. Scientific Beta is a subsidiary of the Singapore Exchange (SGX) and maintains its strong collaboration with EDHEC Business School, adhering to the principles of independent, empirically-based academic research.
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