Because of the specific constraints of their mandate, funds that have an environmental, social and governance bent (ESG Funds) are prompted to overweight certain stocks and sectors, observes Derek Horstmeyer, professor of finance at George Mason University’s School of Business.
As a result, he says, “my research found that the average ESG investor may be taking on more small-cap risk, interest-rate and inflation risk, and single-stock risk than an investor in a standard all-equity fund.”
Along with research assistant Beau Fitzpatrick, Horstmeyer set up a comprehensive list of all equity funds in Morningstar’s data that advertise in their names words such as “ESG”, Sustainable” or “Impact”. He then established those funds’ monthly return over 20 years, correlating their performance to various factors that affect asset prices: short-term interest rates, inflation, oil prices. He replicated the process with the S&P 500 stock universe and compared results.
Is a Tech Bias to Blame?
To begin with, Horstmeyer discovered that, on average, ESG funds show a higher correlation to interest rate and inflation rate changes than the S&P 500. “This may be due, in part, to the average ESG fund’s overweighting to the technology sector,” explains the researcher. Indeed, ESG funds have on average an exposure of about 30% to the technology sector, compared to 27% for the S&P 500.
The higher exposure to interest rates and inflation, thinks Horstmeyer, stems from the fact that technology companies typically expect the majority of their cash flows to materialize in the future. That gives these companies and stocks higher sensitivity to interest and inflation rate changes than companies in other sectors.
The impact on returns of that overexposure is not huge, but not insignificant either. Over the last five years, since technology has been the driver of stock market performance, that overexposure to technology gave an edge to ESG funds of about 30 to 40 basis points, calculates the researcher, “just from the overweight of technology, everything else being equal.” However, he quickly points out, the reverse is also true: “In downturns, your ESG fund will fall more than the S&P”.
In fact, Horstmeyer’s research finds that, at the higher end, one in 15 ESG funds has a technology overweight of 40%. “That’s a very heavy weight compared to your typical large cap or fund any straight equity fund that would replicate the S&P’s tech exposure (of 27%).” However, that’s only the upper limit. Many other funds line up after that with a technology exposure of 39%, 38%, and so on.
Overall volatility of ESG funds, Horstmeyer finds, stood annually at 15.46% over the last 20 years, compared to 15,04% for the S&P 500. He explains that in large part by the larger proportion of small cap stocks in ESG funds, pointing to the 0.876 correlation the average ESG fund has to the small cap Russell 2000 index over 20 years, while the Russell 2000 index holds a 0.841 correlation to the S&P 500. “And we know that the Russell 2000 index is more closely synchronized with the general business cycle,” the researcher points out.
Oil “Dependence”
Paradoxically, though the average ESG fund doesn’t hold oil and gas stocks, it is more heavily exposed to changes in oil prices – the sector which most ESG proponents love to hate. “The likely explanation is that oil prices often reflect changing economic conditions around the world, and ESG funds are more heavily weighted toward cyclical industries such as tech and consumer goods.”
One last significant risk ESG funds carry is single-stock risk: the largest holding of one in 10 ESG fund weighs 10% of the overall portfolio. “There is considerable risk in focusing that much weight on one holding in a fund,” Horstmeyer notes.
Horstmeyer is not telling ESG investors to panic, but “investors should be aware of these risks before picking out a fund.” Of course, for individuals who are set on “saving the planet”, these higher risks are a small price to pay. But that is not the mindset of all ESG investors. An increasing number are into ESG investment essentially for financial reasons, and should be aware of the risks. “I think some know, but a majority could be surprised,” Horstmeyer believes.
Horstmeyer’s findings don’t faze Hortense Bioy, Global Director of Sustainability Research, Manager Research, at Morningstar. “It’s good to know, she says, that ESG funds face more small-cap risk, interest-rate risk, and exposure to oil prices because of their bias towards technology companies, but this sector bias is well known. It has been one of reasons why ESG funds have performed well.”
