What sets apart top performing ESG equity funds?

This article was written by Nakul Nair, Data Science Specialist at Bloomberg.

There are about 4,700 ESG funds that are focused on equity investing, which manage around $4 trillion in assets. This makes equity the largest and most popular asset class within the ESG space. Nearly double the abundance and AUM of its two nearest rivals – fixed income and mixed allocation focused funds.

A strong performance profile likely makes equity focused ESG funds very desirable. We examined this in our first blog, ESG funds: What makes for good performance? Given their popularity and performance, this next blog in our ESG Playbook series uses Bloomberg’s Funds Data Solution to analyze the characteristics of top-performing equity focused ESG funds. We look at the impact of market focus, scores correlation, cost, and leaders versus improvers on a fund’s bottom line.

1. Funds that focus on specific markets fare better than ones with a global remit

We examined the 3-year total annualized returns by geographic focus for regions that have over 100 funds. These returns were benchmarked to the following indices: Japan – Nikkei 225, Europe – Euro Stoxx Index, U.S. – S&P 500 Index, Multi/Global/International – World Index since they represent an easily accessible investment alternative for investors.

Starting with absolute returns, it is clear from Figure 1 that funds focusing on specific markets like Japan, US, or Europe generated better returns than their multi-region counterparts. Of these, Japanese funds have generated the best returns, followed by Europe and then the US.

Yet, on a relative basis, European funds tracked far closer to overall market performance in their region than their two closest competitors. This indicates that there is a lower opportunity cost for ESG investing in Europe.

Importantly, the comparison to the benchmarks only matters if an investor is seeking to deploy capital and is choosing between an ESG option and a more generic market option. If the mandate from the outset is to invest in an ESG fund, the return delta to the market would carry less importance.

2. ESG scores have a positive correlation with returns

We next look at Bloomberg’s fund-level ESG scores & analytics as they serve as a proxy for ‘impact’, measuring the societal and environmental benefits of the investment.

Figure 2 displays returns by their respective E, S, and G scores. There is a clear positive trendline across all three metrics – implying that there is a correlation between returns and ESG scores. Of the three, environmental scores are seen to have the most positive correlation with returns.

Overall, top-performing equity focused ESG funds tend to have higher scores. This not only boosts their impact profile but seems to result in better returns.

3. The cost of a fund does not have any bearing on their returns nor ESG-ness

The cost required to invest in a fund is typically expressed as an expense ratio. Using this measure, we investigate questions such as: does paying more for a fund guarantee better performance? Are your returns better, or do you get more impact for more expensive funds?

As shown in Figure 3, the answer is no to all the above—at least within our subset of 4,700 equity ESG funds. There is clearly no relationship in either chart. More expensive funds tend to generate just as much as their cheaper counterparts. More expensive funds also tend to rank similarly in terms of ESG scores as their cheaper counterparts, indicating it is good to keep an eye on your expense ratio because you are not necessarily getting more bang for your buck.

4. ESG leaders generate better returns within equity-focused funds

While we have outlined some of the major characteristics of top performing ESG funds, it is important to note that investments are typically made through strategies, not by assessing summary statistics. To account for this, we look at one popular investment thesis which involves investing in either ESG ‘leaders’ or ‘improvers’.

Leaders are funds with the best ESG profiles. In our case, this involves securities with the highest ESG scores. Meanwhile, improvers are defined as securities that improve the most in terms of their ESG profile, or again in our case, ESG scores over a set time period.

As such, we defined leaders as the top 240 firms with respect to their ESG score as of September 2022. Improvers are the funds with the biggest gain in their ESG score between September 2022 and June 2023. The availability of point-in-time historical data makes this type of analysis possible.

Figure 4 shows the cumulative product of returns from each of these subgroups between September 2022 and June 2023. Over the time period within our sample of funds, ESG leaders generated better returns than ESG improvers. This outcome is only valid within our subset of equity ESG funds and the difference between the leaders’ returns and improvers’ returns is relatively small so could be a function of the samples taken.

However, despite this preliminary finding, there can be value to investing in ESG improver funds as these companies require capital to enhance the sustainability of their operations. Once operations are overhauled, they could be better positioned both in terms of impact and overall returns. For more on this topic, a recent Freakonomics podcast investigates this question, Are E.S.G. Investors Actually Helping the Environment?

Highlights of ESG equity funds

To recap, top performing ESG funds tend to focus on equity as we overviewed in the first blog in our ESG playbook series.

Equity funds that focus on specific regions tend to outperform multi-region or global funds on returns. Returns are correlated with ESG scores—funds with higher scores often also generate strong returns.

We also found that expense ratios have negligible impact on how a fund will perform and investing in ESG leaders may provide slightly better results than investing in improvers but there is a benefit to prioritizing improvers.

Bloomberg’s newly launched enterprise funds data solution was used to analyze the ESG equities funds market. To conduct your own analysis, learn more here.