ESG-friendly US equities have been underperforming. Why?

Receive free ESG investing updates

We’ll send you a myFT Daily Digest email rounding up the latest ESG investing news every morning.

Do non-toxic investment strategies do better than the other type? It’s a surprisingly tricky question to answer.

Of course, ESG is a mess of compromises and arbitrary categorisations that have been grafted on to a fundamentally incoherent and probably counterproductive concept. There’s no ignoring it though, much as we’d like to, so it’s perhaps worth parking the big-picture stuff and taking a moment to consider a performance measurement problem.

Approximately $18tn+ of assets under management wear an ESG badge. Their higher fees are justified by a promise of superior long-term returns as well as metricised do-goodery. But figuring out whether they deliver on the promise gets very complicated very quickly.

It’s not enough to compare returns from an ESG-focused index with its parent, because the former’s smaller universe means they can’t share the same sector allocations and risk exposures. Assets labelled ESG are usually bigger and higher quality (in the Benjamin Graham sense of the word) than the wider index average, plus stuff like rebalancings will have substantially different effects, so it’s never an apples-with-apples comparison.

Barclays analysts took on the measurement problem a few years ago. Their idea was to build two portfolios that were identically matched for risk and sector weighting, but with ESG scores set to maximum and minimum, respectively. It’s an interesting approach because not only does it measure the sanitised portfolio’s excess returns, the E S and G bits can be adjusted individually.

Between 2014 and 2020, ESG equities basket outperformed both in the US and Europe, Barclays found. But since 2021, Wall Street has reversed.

Why? It could be a reflection of regulation (and promotion) of ESG, which in the US is even more of an uncoordinated mess than in Europe, says Barclays:

 In the US, the SEC, CFTC and others are making strides at the federal level (eg, the SEC rule on fund labeling and proposed rule on corporate climate disclosures) but the picture at state-level is more mixed; California recently passed a climate disclosure law that moves ahead of the SEC rule, while other states have put forth anti-ESG legislation. Conversely, Europe has taken a more proactive and unified approach and has been earlier to implement more stringent ESG regulations and guidelines for companies (eg, the Corporate Sustainability Reporting Directive (CSRD) and Corporate Sustainability Due Diligence Directive (CSDDD)) and investors marketing ESG funds (eg, the Sustainable Finance Disclosure Regulation (SFDR)). These differences in mandates and regulations may lead to different return effects.

But if it’s all politics, credit markets should look similar to equities. They don’t. ESG premiums are still measurable on both sides of the Atlantic.

As ever, there’s a problem with comparing apples with things that aren’t exactly apples, since the corporate makeups of the equity and credit indices won’t match.

Weirdly though, using an overlapping sample gives a similar result: US and European ESG credit outperform their benchmarks, ditto European ESG equities, but US ESG equities don’t. The table below is equity-credit matched by overlap and, just in case you’re going number blind by this point, we’ve highlighted in red the relevant line.

As mentioned earlier, it’s possible to set two out of E, S, or G at the benchmark level to reveal the importance to performance of the third. This is where things get even weirder.

The charts here suggest equity investors in the US have gone right off the environment (-2.75 per cent annualised underperformance versus benchmark since 2021), while not really caring much for social responsibility or corporate governance either (-1.33 per cent and -1.66 per cent respectively). Meanwhile, in Europe, the E and G components have been similarly negative. It’s the S has been carrying all the weight and maintaining overall outperformance:

A symptom of ESG’s apparent bias against mass employers and love of big tech’s low capitalisation-to-employee ratios? Uh, maybe, though that’s not how it looks from the credit side.

In fact, in many ways the equity and credit performance charts look like opposites, which doesn’t say much for the essential principles of purpose-driven investment selection that are meant to be on display:

There’s been a turn in the narrative of late, with anti-ESG investing on the rise and short sellers keen to tell us about how the space has dumb money chasing mediocre and mislabelled assets. But then, market outperformance was always a daft argument for ESG, for all the reasons discussed often by our friends at Unhedged.

The most cogent argument in favour of impact investing — that it lowers the relative cost of capital for nice companies by bidding up their value while doing the opposite for nasty ones — has a natural trade-off is that for it to work, investors would need to accept lower returns. The evidence presented above might suggest that investors in US stocks have finally grasped this reality and don’t like it.

The broader picture told by the data remains chaotic, however. And for as long as chaos reigns in the ESG industrial complex, there will be no shortage of shiny sales executives with glossy brochures that say “do well by doing good” on the cover.

Further reading:
— Lord make me ESG, but not yet (FTAV)