Commentary by Jan-Carl Plagge, Global Head of Active-Passive Portfolio Research, Investment Strategy Group, Vanguard Europe.
‘Style factors’, such as ‘size’, ‘value’ and ‘quality’, are widely known to impact the performance of equities or bonds. Exposures to these factors can have a positive, neutral or negative impact on returns, depending on the direction of an asset’s exposure and the performance of the factor.
In many cases, index or active funds have a deliberate ‘tilt’ towards one, or more, factors. These tilts can stem from an index methodology (for index funds) or result from a manager’s decision (for actively managed funds).
But can style factors also influence the performance of ESG equity funds?
The fact that many ESG funds persistently under- or overweight certain sectors offers a clue that ESG funds may have some systematic exposures to style factors. For example, we found that the market capitalisation-weighted aggregate of ESG equity index funds with a US investment focus overweights technology and financials and underweights stocks from the energy and industrials sector1. If these sectors are linked to investment styles, it can reasonably be expected that sector deviations translate into style factor exposures.
Our research shows that the performance of many ESG funds has indeed been impacted by style factor exposures. We analysed the gross (that is, before cost) returns of a wide selection of ESG equity funds over the course of the five years ending in 2021—both index and active—in a style factor framework2. We used style factors from the Fama and French (2015) five-factor model, which includes the market factor (in our case, the US equity market return) and four style factors: size, book-to-market (representing value versus growth), profitability and investment3.
Factor exposures and alpha – index and active ESG equity funds
Source: Vanguard calculations based on data from Morningstar, Inc. and Kenneth French’s website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html Notes: The bars show the share of funds for which the regression coefficient was either positive or negative and statistically significant at a level of at least 10%. The underlying coefficients result from regressing every sample fund’s monthly gross returns against the returns of the US equity market return (MktRf) and the four Fama and French (2015) style factors: Size (Small Minus Big – SMB), book-to-market (High Minus Low – HML), operating profitability (Robust Minus Weak – RMW) and investment (Conservative Minus Aggressive – CMA). For better visibility, the figure does not include the market factor. Time period observed: 1 January 2017 to 30 November 2021.
The charts show the share of funds that had a positive and a negative exposure to each one of our tested factors4. We found that the exposure to the market factor was positive for every single fund in our sample. This should not come as a surprise, as all the funds we analysed invest solely into the US equity market.
Looking at style factors, most index funds (67%) in our sample had a large-cap tilt relative to the broad US equity market, while only a small portion of funds overweighted small-cap stocks. Among active funds, the share was also more tilted towards large-cap, although not as clear-cut as with index funds.
For the value (book-to-market) factor, roughly 50% of both index and active funds had a statistically significant exposure to this factor. Contrary to what some investors may expect, among these, the majority of funds had a positive—that is, value—tilt.
As for the investment factor—which refers to how conservative or aggressive the investment philosophies of underlying companies are—index and active funds differed in their exposures. While the factor mattered for 40% of funds in both categories, among index funds, the exposure was predominantly positive, while it was largely negative for active funds.
Only a minority of funds had a statistically significant exposure to the profitability factor, which measures whether the operating financial performance of companies is robust or weak.
And when it came to factor-adjusted alphas—the systematic part that remains after controlling for the market factor and for the four style factors—only about 20% of the funds in our sample had a statistically significant alpha (positive or negative). Thus, for roughly 80% of ESG funds in our sample, we have to assume that alphas are no different from zero - and hence that our five factors explained the systematic part of their performance.
So, what should investors take away from our findings? It is important for investors to acknowledge that ESG funds—irrespective of whether they are actively managed or linked to an index—can bear active risk5. This is because they typically over- or underweight—or altogether exclude—specific companies or even entire sectors. In some cases, these deviations can translate into systematic exposures to known style factors. These style tilts subsequently impact performance - both positively and negatively, depending on the direction of the exposure and the performance of the factor.
These are just more reasons why ESG-conscious investors shouldn’t draw conclusions when it comes to ESG funds before thoroughly investigating the constituents and philosophy of each individual fund they are considering. Otherwise, this could lead to unexpected—and unwelcome—results.
1 We conducted a performance attribution based on Brinson, G., R. Hood, and G. Beebower. 1986. “Determinants of Portfolio Performance.” Financial Analysts Journal 42. ©  With Intelligence, LLC. Republished with permission of PMR Journal of Impact & ESG Investing, [“Explaining ESG Equity Index Fund Performance - Is it all about Industry Allocations?”, Volume 2, Issue 3]. All rights reserved.
2 To identify ESG funds, we focused on all funds that Morningstar classifies as ‘Sustainable Investment – ESG Incorporation’. These are strategies that indicate the use of any sort of environmental, social and/or governance factors in their investment process.
3 Our analysis involved running regression modelling of the gross returns of all ESG funds against the Fama and French (2015) five-factor model. The four Fama and French style factors referenced are: Size, or Small Minus Big (SMB) - the average return on small stock portfolios minus the average return on big stock portfolios; book-to-market, or High Minus Low (HML) - the average return on value portfolios minus the average return on growth portfolios; operating profitability, or Robust Minus Weak (RMW) - the average return on robust operating profitability portfolios minus the average return on weak operating profitability portfolios; and, investment, or Conservative Minus Aggressive (CMA) - the average return on conservative investment portfolios minus the average return on aggressive investment portfolios. The other factor in the five-factor model is the market factor (MktRF).
4 We only consider a style exposure to be different from zero if it is statistically significant at a level of at least 10%. This is the reason why the two bars shown for each style factor may not add up to 100%. The 10% is a level often applied by academics and practitioners. One often refers to the 10% by saying that a result is ‘statistically significant’ at 10%.
5 We assume ESG index funds bear active risk because they are constructed differently than a conventional total market index fund. We also assume the absence of optimisation techniques that aim at minimising active risk between an ESG fund and the market.
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