ESG funds: What makes for good performance?

This article was written by Bloomberg’s Data Science Specialist Nakul Nair.

Environmental, Social and Governance (ESG) labelled funds hold approximately $7 trillion in assets according to Bloomberg’s analysis of 14,500 funds with ESG called out in their prospectus. A threshold indicating that this sector has achieved mainstream status. Despite this, the sector still has much work to do to overcome the challenges it was designed to tackle such as limiting global warming and creating more equitable corporate governance practices, among others.

To get there, more investment is needed. In theory, performance will drive this investment. Better performance will attract more activity, spawning new funds and drawing in more capital. But how is performance defined for ESG funds? What constitutes good performance? How are top funds achieving the best performance outcomes?

Typically, investment performance is assessed across two main axes: returns and risk. The former dictates how much you receive in return for what you put in. The latter examines how likely you are to get back what you expect to receive – how sure of a bet is the returns you are expecting.

When it comes to ESG investments, there is a third axis that must be considered: impact. Are your investments in line with your ESG investment mandate?

Performance = Returns – Risk + Impact

With this framework in mind, we evaluate top-performing ESG fund types across equity, mixed allocation, and fixed income. Using Bloomberg’s newly launched enterprise Funds Data Solution, this blog analyzes approximately 14,500 mutual funds, fund of funds, and open-end funds across the Americas, Europe, and Asia. Exchange traded products like ETFs are not included. We look at which fund types generate the best returns, have the lowest risk, and deliver the most impact.

1. Equity ESG funds generate the best returns

Starting with returns, Figure 1 displays the 3-year total return for ESG labelled funds and comparable indices by asset class: equity, mixed allocation, and fixed income. These indices represent an easily accessible investment alternative for investors.

As shown, funds that invest in equity not only generate the best returns within the ESG-labelled space, but they also outperform those comparable indices. While mixed allocation and fixed income ESG funds also fared better than their corresponding indices, the shortfall in returns compared to equity focused ESG funds is massive.

ESG labelled funds generating better returns than their corresponding index is a noteworthy takeaway. It challenges the notion that there is an opportunity cost associated with investing in ESG – a conscious investor does not necessarily need to relinquish returns.

2. Equity funds are not without their risk

Now let us consider risk. Figure 2 shows the distribution of return volatility by asset class for ESG funds (bars). The median of the bars is plotted as solid lines with matching colors e.g., the solid blue line is the median for the blue bars.

By comparing the solid vertical lines, you can see that equity funds have the greatest median volatility as they are furthest right along the X-axis. Mixed allocation is next, and fixed income ESG funds are the least risky.

The dashed lines depict the volatility of the corresponding market index over the same time period.

Therefore, the distance between the dashed line and the solid line of the same color represents how much riskier ESG funds of that asset class are versus the broader market.

This distance is largest for fixed income funds, which means that even though fixed income is the least risky overall, it is the riskiest compared to its broader market index. Equity funds are next, and mixed allocation ESG funds risk is the closest to that of its market.

ESG funds have a smaller investable universe than their broader market index so having greater risk is not too surprising. The fact that mixed allocation funds achieve a similar risk level despite the narrower scope is a major benefit of investing in ESG through that asset class.

3. Mixed allocation funds score the best on “impact”

There is still the third pillar to consider – impact. Impact is a hard concept to quantify. In this analysis, we use Bloomberg’s fund-level ESG scores & analytics as our benchmark for impact since they measure a company’s management of financially material ESG issues. The scores combine Bloomberg’s holdings data with its premium security-level data so customers can drill down to determine if a fund truly meets sustainability criteria.

Figure 3 shows a weighted average ESG score by asset class revealing that mixed funds have the best average rating, followed by equity and then fixed income.

In sum, equity funds have the best returns but are the riskiest. Mixed funds have a much more modest return but see the lowest volatility and have the highest ESG score. Essentially, top performing ESG fund types typically invest in either equity or have a mixed allocation. As an investor, the asset class to focus on depends on how you weigh the individual axes of performance: returns, risk, and impact.

To learn more about Bloomberg’s Funds Data Solution used in this analysis, please visit our website here.