This is an excerpt from an Advisor Perspectives’ article, by by Larry Swedroe

An ESG mandate fulfills the noble goal of aligning investors’ portfolios with their personal values and beliefs. But new research affirms what financial theory predicts: Those investors will incur a penalty in terms of risk-adjusted performance.

Over the past decade, there has been a dramatic increase in ESG (environmental, social, governance) investing strategies. In their “2018 Report on U.S. Sustainable, Responsible and Impact Investing Trends,” the US SIF Foundation found that assets denoted as socially responsible products “grew from $8.7 trillion at the start of 2016 to $12.0 trillion at the start of 2018, a 38% increase. This represents 26% of the total U.S. assets under professional management.

ESG strategies allow investors to express their social views through their investments. This helps explain why a recent survey by FTSE Russell showed that of the nearly half (46%) of global asset owners that have an allocation to smart beta, 41% of those using it anticipate applying ESG considerations.

While providing the benefit of being able to express their social views, investors should also be concerned about how these strategies perform. Wayne Winegarden, of the Pacific Research Institute, contributes to the literature with his May 2019 study “Environmental, Social, and Governance (ESG) Investing: An Evaluation of the Evidence.” He evaluated the performance of 30 ESG funds that had either existed for more than 10 years or had outperformed the S&P 500 Index over a short-term timeframe. The following is a summary of his findings:

  • Of the 18 ESG funds examined that had a full 10-year track record, a $10,000 ESG portfolio (equally divided across the funds, including the impact from management fees) would be 43.9% smaller after 10 years compared to a $10,000 investment into an S&P 500 Index fund.
  • Only one of the 18 funds exceeded the return of an S&P 500 benchmark investment over a five-year investment horizon, and only two were able to beat the S&P 500 benchmark over a 10-year investment horizon.
  • ESG funds were more expensive, with an average expense ratio of 0.69% versus the much lower (single-digit) expense of an S&P 500 Index fund. The average expense ratio of the subcategory of ESG funds that focused on social goals was an even higher 0.89%. Over long investment horizons, these much higher expenses create a significant drag on returns, assuming returns are similar otherwise.
  • ESG funds were also riskier as measured by concentration. On average, their top 10 holdings constituted 37% of the portfolio compared to 21% for a broad-based S&P 500 Index fund, significantly reducing diversification benefits. In one fund, the VanEck Vectors Environmental Services ETF (EVX), the top 10 holdings represented 64% of the portfolio – I found that as of May 28, 2019, the top four holdings comprised 43% of the portfolio. Concentration at these levels imposes large risks on investors.

Winegarden concluded: “Judged against past performance, ESG funds have not yet shown the ability to match the returns from simply investing in a broad-based index fund. Explicitly recognizing this tradeoff is essential to enable investors to better pursue their financial goals in the manner that reflects their values and the costs they are willing to bear.”

Winegarden also provided this insight from a study by Professor Tracie Woidtke published in the January 2002 issue of the Journal of Financial Economics. Woidtke examined the impact from activist public pension funds on the market values of a sample of Fortune 500 companies. Woidtke found that increased shareholder activism by public pension funds is negatively correlated with stock returns! Particularly noteworthy, the firms that received proposals from public pension funds that were demonstrably advancing social agendas were valued 14% lower than similar companies that did not receive such proposals. Woidtke highlighted the importance of this by noting, “The Manhattan Institute’s Proxy Monitor Report found that in 2017, fully 56% of shareholder proposals at Fortune 250 companies dealt with social or policy concerns.” She added, “A striking survey released earlier this year by the Spectrem Group found that 88% of public pension plan beneficiaries want plan assets to be used for maximizing returns and not political agendas, even if they agree with whatever cause the overseers of the plan may be advocating.”

Unfortunately, a 2018 Manhattan Institute study found “a positive association between recommendations by proxy advisory firms (such as ISS and Glass Lewis) and shareholder voting and a negative relationship between share value and public pension funds’ social-issue shareholder-proposal activism (which is much more likely to be supported by proxy advisory firms than by the median shareholder).” Winegarden noted: “These negative associations emerge because the two major proxy advisory firms establish their position on ESG without adequate transparency, without considering how the programs can impact different investors (the advisory firms generally employ a one-sized fits all approach to deciding issues), and their internal ESG advisory programs demonstrate a conflict of interests/bias. As a result, institutional investors (particularly public pension funds) may be violating their fiduciary responsibilities when they adopt the ESG voting positions suggested by these proxy advisory firms.”

Winegarden’s results were similar to those I found in my April 10, 2019, article, “ESG Strategy Performance.” In each of the three MSCI ESG Index returns I examined (ESG Select, ESG Leaders and ESG Universal), they provided lower returns, and lower risk-adjusted returns, than the broad market index. In addition, these results are consistent with those found in other academic papers, which I examined in my article of March 30, 2018, “Principle Over Profits.


It is critical that investors explicitly recognize the tradeoffs between ESG goals and financial returns. While ESG investing continues to gain in popularity, economic theory suggests that, if a large enough proportion of investors chooses to avoid the stocks of companies with low ESG ratings, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower price-to-earnings ratio. Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies). Academic research that I reviewed in a recent article has confirmed the evidence supports the theory. With this knowledge, investors are positioned to pursue their financial goals in the manner that reflects their values and the costs they are willing to bear to achieve those values.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.