Is there a performance cost to ESG investment?

08 June 2020 | Topical insights


Jan-Carl Plagge, PhD

Senior investment strategist, Vanguard Europe

Recent years have seen strong growth in the popularity of investing in funds with an environmental, social and governance (ESG) dimension1,2. Motives sit on a spectrum between a desire to increase risk-adjusted returns to satisfying a value preference or effecting meaningful change.

Irrespective of their motivation, many investors wonder whether moving from a non-ESG to an ESG investment should influence their return expectations.

The academic literature is divided on the issue. Some argue that, over the long term, the stocks of companies that demonstrate good ESG behaviours will outperform those that do not. Conversely, others argue that the stocks of companies demonstrating good ESG behaviours are likely to underperform. This may happen for a range of reasons, such as costs related to ESG compliance outweighing the benefit.

Other theories predict that ESG-related behaviours have no direct impact on performance, either because they are not financially material, or because market prices capture relevant ESG information through factors such as style or industry-specific attributes3.

Next to these stock-specific considerations, there is a portfolio dimension to consider because ESG funds often exclude specific sectors or companies that are engaged in certain business activities from the investable universe. This reduction in the opportunity set may lead to a sub-optimal risk-return outcome.

As ESG issues continue to grip the public imagination, there can be little doubt that the number of individuals and institutions wanting to use investment to reflect their values will continue to increase. The question of whether ESG funds deliver risk-adjusted returns consistently different to the market is therefore likely to become more and more important.

Our research has found that ESG funds can behave very differently to the underlying market. In many cases, this is due to differences in style and/or industry tilts, suggesting that investors in these funds are likely to bear varying degrees of relative risk.

However, the research also shows that ESG funds behave very differently from one another. While some funds delivered better returns than the market, others underperformed. Looking at factor-adjusted gross alpha, we found that the majority of funds in our sample had an alpha that was indistinguishable from zero. Thus, while we do see differences in performance, these differences can often be explained by known factors.

Returns and volatility

A core component of our research was an examination of the gross (before costs) performance of US equity mutual funds and ETFs that indicate the use of ESG factors in their investment process, as determined by Morningstar.

We focused on US equity as a large and homogeneous market where our results would not be distorted by differences in country-specific characteristics.

For our analysis, we distinguished between index and active funds as well as between funds that apply explicit exclusions and those that do not. In order to find a good balance between the historical reach as well as coverage of funds, we divided our sample period into three sub-samples, ranging from 2004 to 2008, from 2009 to 2013 and from 2014 to 2019. This further allowed us to capture funds that came into existence more recently.

In the first step, we investigated raw differences in gross returns and volatility (standard deviation) for all funds and time periods relative to the FTSE USA All Cap Index.

Across the sample, we noticed a high level of dispersion along both dimensions – differences in return as well as risk. We found ESG funds with higher return and higher risk, lower return and lower risk, as well as higher return and lower risk and lower returns and higher risk than their investment universe. As one might expect, active fund results are more dispersed than those of index funds. Overall, these initial findings suggest that ESG funds neither have systematically higher nor lower risk-adjusted returns than the broader market

Do ESG funds deliver a factor-adjusted gross alpha?

In the second step, we decomposed these return differences to see whether we could identify any potential alpha across our chosen set of ESG funds.

There has always been an element of suspicion that ESG performance is related to factor tilts that may or may not be an explicit element of a fund’s approach. For example, ESG screens may favour new technologies. These companies may be comparably smaller and show strong growth potential, reflected in higher price-to-book valuations.

In order to control for possible style factor tilts, we regressed the performance of our ESG funds against the Fama-French five factor model: a market factor, size, valuation (value/growth), profitability (quality) and capital investment. 

Unsurprisingly, we found the market factor to be highly significant across the entire fund universe. The influence of style factors, on the other hand, was much less consistent. We identified many funds with significant style factor exposures but no clear picture emerged. Some funds had statistically significant and positive exposures to a given factor, others had a significant but negative exposure to the same factor, while again others had no noteworthy exposure to that factor at all.

We found the dispersion of these exposures to be slightly higher for active funds than for index funds. Similar differences emerged when distinguishing between funds that apply explicit exclusions and those that do not: the dispersion in factor tilts for exclusion-based funds was slightly lower than it was for non-exclusionary funds.

Having controlled for style factors, we turned our attention to the funds’ gross alpha, in order to assess whether we could identify an independent component that may be attributable to the ESG element. In the majority of cases, however, we found gross alphas to be indistinguishable from zero, statistically speaking.

Sector deviation

The third step of our analysis focused on the examination of the sector deviations of ESG funds and their potential impact on fund performance.

Just as an ESG fund may favour new technologies, it may avoid other sectors, such as those relating to fossil fuels. In order to make potential biases explicit, we determined the sector exposures of all ESG funds in our sample. Our analysis, using FactSet sector classifications, revealed deviations in sector allocations relative to the broad market for many ESG funds. In median terms, finance, energy minerals and consumer services were found to be slightly underweighted, while health technology was found to be slightly overweighted.

However, when assessing the potential impact that these systematic deviations in industry exposures had on relative fund performance, we found the effect to be very small in median terms when sampled on a quarterly basis across the sample period of 15 years and all funds observed. 

Impact of costs

As our analysis thus far was based on gross returns, we calculated net (after cost) alphas and analysed their relationship with expense ratios. There was again a significant dispersion in the results. However, we identified a negative relationship between net alphas and expense ratios across the broader sample.

Costs have a significant impact on alpha in ESG funds

Notes: Relationship between net alpha and average over monthly expense ratios. Monthly expense ratios are calculated as the difference between gross and net returns. The exhibit includes data from three five-year periods: 2004 to 2008, 2009 to 2013 and from 2014 to 2018. Funds are those focused on US equities using ESG as a factor in their investment process, as identified by Morningstar. Benchmark is FTSE USA Equity All Cap.

Sources: Vanguard calculations based on data from Morningstar, Inc.

© 2020 PMR. All rights reserved. Journal of Portfolio Management Vol 46 Issue 3 Ethical Investing 2020.


Given these differences in risk-return outcomes, and the high degree of heterogeneity in the construction and management of ESG funds, our view is that investors should assess potential investment implications on a fund by fund basis, both on an absolute basis as well as relative to the fund they may move away from as a result of their ESG investment


1 According to Global Sustainable Investment Alliance (GSIA), the global assets in ESG screened strategies more than doubled from $12.3 trillion in 2012 to $26.3 trillion in 2018.

2 This article is taken from research originally published in the Journal of Portfolio Management: Plagge, J.-C. and D. M. Grim. 2020. ’Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds.’ JPM Vol 46 Issue 3 Ethical Investing: 123–140.

3 Blitz, D., and F. J. Fabozzi. 2017. “Sin Stocks Revisited: Resolving the Sin Stock Anomaly.” The Journal of Portfolio Management 44 (1): 105–111.


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