By Jan-Carl Plagge, Global Head of Active-Passive Portfolio Research, Investment Strategy Group, Vanguard Europe.

The performance implications of investing in funds that deviate from the broader market is a perennially popular topic with investors. The rapidly expanding world of environmental, social and governance (ESG) funds, which often exclude specific subsets of the broader market or overweight others, is no exception.

As the choice of ESG funds continues to grow, many investors might wonder what impact moving from a non-ESG to an ESG mandate will have on the returns they can expect to achieve. The question of whether ESG funds deliver return characteristics consistently different from the market is therefore likely to become more and more important.

Positive, negative or no impact on performance?

The academic literature is divided on the issue. Some theories predict that, over the long term, the stocks of companies that demonstrate good ESG behaviours will outperform those that do not; others that they are likely to underperform. There is also the view that ESG-related characteristics have no direct impact on performance.

Beyond stock-specific considerations, there is also a portfolio dimension to consider. ESG funds often exclude from the investable universe specific sectors or companies that are engaged in certain business activities. This reduction in the opportunity set may impact return expectations too.

We conducted research—originally carried out in 2019 and now updated with data to the end of 2021—looking into whether there was a performance cost to ESG investment1, and our findings showed that ESG funds could behave very differently to the underlying market. While some funds delivered better returns than the market, others underperformed. Hence, our research showed that ESG funds not only deviated from the market but also from one another. In many cases, this was due to differences in style and/or industry tilts, suggesting that investors in these funds were likely to bear varying degrees of relative risk.

Looking at factor-adjusted gross alpha, we found that the majority of the funds in our sample had an alpha that was indistinguishable from zero. In other words, our analysis of ESG equity funds relative to the broad underlying market found that the vast majority of funds in our sample did not produce superior factor-adjusted returns. Thus, while we did observe differences in performance, these differences could often be explained by known factors.

Analysing returns and volatility

A core component of our research was an examination of the gross (that is, before costs) performance of US equity mutual funds and ETFs that indicate the use of ESG factors in their investment process, as determined by Morningstar. We distinguished between index and active funds, dividing our sample period into three sub-samples, ranging from 2007 to 2011, from 2012 to 2016 and from 2017 to 2021. This further allowed us to capture funds that came into existence more recently.

We started by investigating raw differences in gross returns and volatility (standard deviation) for all funds and time periods relative to the FTSE USA All Cap Index. In the chart below, we show these differences for the most recent of our three five-year periods (2017 to 2021).

Risk and returns for ESG funds were highly dispersed across the sample. As one might expect, active fund results are more dispersed than those of index funds. Overall, these initial findings suggest that ESG funds neither have altogether higher nor lower risk-adjusted returns than the broader market.

High dispersion in ESG fund risk and returns

Past performance is not a reliable indicator of future results.
Sources: Vanguard calculations based on data from Morningstar, Inc.
Notes: The data points reflect the difference in annualized 5-year standard deviation and gross return of each equity index fund and the broad US equity market as proxied by the FTSE USA All Cap Index. Included funds: index funds, active funds with US investment focus that are classified as ‘ESG incorporation’ funds by Morningstar. Time period observed: 1 January 2017 to 31 December 2021.  Returns are calculated in USD based on NAVs.

Examining factor-adjusted gross alpha

There has always been an element of suspicion that ESG performance is related to factor tilts that may or may not be an explicit element of a fund’s approach. For example, ESG screens may favour new technologies which, in turn, may lead to a specific factor exposure. In light of the potential distortions that such factor tilts may cause, we went beyond just looking at return differences between ESG funds and the market and applied a methodology that allowed us to isolate the portion of return difference that is left after controlling for style tilts. This regressed a fund’s performance against not just the market return but also against style factor returns. We used the Fama-French five-factor model, which contains a market, a size, a valuation (value/growth), a profitability and a capital investment factor.

Unsurprisingly, we found the market factor to be highly significant across the entire fund universe. The influence of style factors, on the other hand, was much less consistent. While we identified many funds with significant style factor exposures, no clear picture in terms of direction emerged. We found this to be the case across both active and index ESG funds.

Having controlled for style factors, we were now able to assess whether we could identify an independent component of the funds’ gross alpha that may be attributable to the ESG element. However, as with our original analysis, in the majority of cases we found gross alphas to be indistinguishable from zero, statistically speaking.

Costs and net alpha

Up to this point, our analysis had been based on gross returns. Next, however, we calculated net (that is, after-cost) alphas and analysed their relationship with expense ratios. As with the risk and returns of ESG funds, here there was also significant dispersion in the results.

Despite the dispersion, we did, however, identify a negative relationship between net alphas and expense ratios across the broader sample on average. In other words, higher ESG fund management expenses tend to be associated with lower net alpha.

The impact of costs on alpha in ESG funds

Sources: Vanguard calculations based on data from Morningstar, Inc.
Notes: Alphas are based on monthly fund net returns over the risk-free rate measured using the Fama and French (2015) five-factor model. Returns are calculated in USD based on NAVs. Monthly expense ratios are calculated as average of the difference between gross and net returns. Included funds: index funds, active funds with US investment focus that are classified as ‘ESG incorporation’ funds by Morningstar. The exhibit includes data from three five-year periods: 2007 to 2011, 2012 to 2016 and from 2017 to 2021.

Fund-by-fund approach

The findings of our research paint a picture of dispersed risk-return outcomes and highly diverse construction and management approaches in ESG funds. Against this background, how can investors best evaluate ESG index and active funds from the plethora available in the marketplace?

Our view is that investors should assess potential investment implications on a fund-by-fund basis, both on an absolute basis as well as relative to the fund they may move away from as a result of their ESG investment. They should also understand the portfolio implications of deviating from a broad market index and what that means for the risk and returns they can expect.

The most important consideration in selecting an approach is likely to be unique to each investor. There is no one-size-fits-all approach and the importance of goals, balance, cost and discipline will remain key to building a portfolio.


1 Research originally published in the Journal of Portfolio Management: Plagge, J.-C. and D. M. Grim. 2020. 'Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds.' JPM Vol 46 Issue 3 Ethical Investing: 123–140. Performance of US index and active equity mutual funds and ETFs that indicate the use of ESG factors, as determined by Morningstar. Time period observed: 1 January 2004 - 31 December 2018. The original research was conducted in 2019 and was then updated with data to the end of 2021.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

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