Skip to content
    1. Alternative Managers
    2. Consultants
    3. Corporations
    4. Family Offices
    5. Financial Advisors
    6. Financial Institutions
    7. Individuals & Families
    8. Insurance Companies
    9. Investment Managers
    10. Nonprofits
    11. Pension Funds
    12. Sovereign Entities
    13. View All
  1. Contact us
  2. Search
  3. Client LoginClient Login
Quarterly Investment Research

Understanding ESG Risk Exposures

Investment products that align with investors' views on environmental, social, and governance issues are increasing in popularity.

 

Investment products attempting to match investors’ views on environmental, social, and governance issues (“ESG”) with corporate behavior have been gaining in popularity. Historically a concern for religious and non-profit organizations, recent retail interest has driven asset flows into the category.

There are three main types of ESG investments. Preferential investments rely on ESG ratings systems that score companies or funds, and attempt to build diversified portfolios with a higher positive exposure to selected issues. Exclusionary funds avoid exposure in certain areas, for example tobacco or fossil fuels. Impact funds invest in sectors or firms that have direct exposure to specific ESG mandates. Because impact investments are frequently less liquid and can have idiosyncratic return characteristics they are not included in this discussion.

Portfolios that exclude sectors are making active portfolio allocation decisions. As active investment strategies it is likely that these exclusions change the risk profile of the portfolio. It is less clear how portfolios that rely on ESG ratings are affected, but it is logical that certain sectors will score better based on business fundamentals. Companies with more free capital and internal resources have a better opportunity to address social and governance issues that impact the generalized systematic ESG scores. There is anecdotal evidence that this is true, suggesting that portfolios relying on rating systems may skew away from companies with exposure to manufacturing, commodities, or transportation, and toward companies in areas like technology or healthcare. These tend to be larger and growth companies.

DATA AND METHOD

We can test this hypothesis using the Fama-French five factor model, which attributes equity return behaviors to five common risk factors including market, size, value, profitability and investment. Profitability and (low) investment factors are proxies for quality, as quality firms are highly profitable and need relatively low investment to maintain their profitability. For consistency and brevity we will limit our analysis to U.S. equity mutual funds. We look at the five-year period ending June 2020 because this gives us the largest possible pool while also making sure there are enough data points to make the analysis statistically meaningful.

Using data from Morningstar we divided a universe of 934 U.S. equity mutual funds into three categories: funds that have an ESG mandate but do not use exclusions, funds that have an ESG mandate and employ exclusions, and funds that do not have an explicit ESG mandate as a benchmark. Each of these groups was further separated into active and passive categories to examine whether an active focus on ESG presents different results than the rote imposition of predefined standards or scores.

PASSIVE STRATEGIES

First we look at passive equity ESG investments. These funds typically start with a traditional index, then overlay some ESG scoring system. They rely on systems that score companies based on predefined methodologies, then sum the individual company scores to the portfolio level, finding a maximum ESG score while limiting tracking error. These strategies may also include broad, formulaic exclusionary screens.

To determine whether these scoring systems impact portfolio exposures we compare them to non-ESG passive funds. Exhibit 1 shows that, on average, the passive implementation of ESG considerations decreases exposures to size, value, profitability, and investment factors relative to non-ESG passive funds. The r-squared across all three categories is very high indicating that these factor betas explain nearly all of the return variation of these funds.

The smaller exposure to size is evidence of increased exposure to large cap companies for the two ESG categories. Similarly the lower value betas are evidence of increased exposure to growth companies. The lower profitability beta is an indication that the companies in passive ESG funds have lower operating profitability.

ACTIVE STRATEGIES

ESG implemented in an active strategy typically goes beyond using third-party ratings. Managers look into company charters and operations, environmental impact, and other issues that may be specific to the fund. This allows them to undergo a more nuanced and thorough analysis of fund holdings.

To examine whether these methods impact portfolio exposures we compare them to non-ESG actively managed funds. Exhibit 2 shows that, on average, the implementation of ESG considerations in active portfolios decreases exposure to size and value, and increases exposure to profitability and investment factors (i.e. to quality). The r-squared is also very high for actively managed funds.

There is slightly more of a large-growth orientation in active ESG funds than passive ESG funds, and the active funds show more exposure to profitability. This is possibly the result of active managers relying on their own research and instead of standardized ratings, selecting companies based on what they see as proactive company level investment in ESG initiatives.

How do these differences affect returns? Exhibit 3 shows that based on beta exposures ESG strategies should have outperformed over our 5-year ESG fund evaluation period. The factor exposures in ESG funds have provided a recent performance advantage, however, over a longer time horizon the performance advantage disappears.

None of the funds in the ESG peer group presented statistically significant alpha, and the average r-squared was very high for all categories. Therefore, any observed difference in performance compared to non-ESG funds is fully explained by the difference in the mix of factor exposures.

The decision to invest in ESG qualified funds is driven by many considerations, some of them quite personal. The imposition of a broad screen or rating scheme based on non-traditional investment considerations is likely to have unintended effects on underlying exposures. Knowing what exposures you are getting is critical in evaluating performance. We have shown that on a factor weighted basis ESG funds do not perform better or worse than non-ESG funds, but they do have inherent factor concentrations that are important to understand.


© 2020 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S.

This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only.

All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.

LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.