What are investors looking for when buying environmental, social and governance (ESG) equity index funds? In principle, as with any fund investment decision, these can be higher financial returns, greater portfolio diversification, lower volatility, etc.

But whatever investors hope ESG funds will deliver, they likely expect them to perform better on ESG criteria than their alternatives. After all, why call funds “ESG” if they don’t consider ESG factors in their investment decisions?

The question is not only academic. ESG funds, including mutual funds and exchange-traded funds (ETFs), have become a $400 billion market in the United States only.

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The first step in testing whether ESG funds offer higher ESG scores is determining what to compare them to.

Many ESG funds track ESG indices which are often provided by third-party index builders such as MSCI and S&P. For example, the SPDR S&P 500 ESG ETF is managed by State Street, has $715 million in assets under management (AUM), and is listed under the ticker symbol EFIV. The EFIV “seeks to provide investment results that, before fees and expenses, generally correspond to the S&P 500 ESG Index,” according to its latest publicly available report. fact sheet.

The S&P 500 ESG Index itself “is a broad, market-cap-weighted index designed to measure the performance of securities that meet sustainability criteria, while maintaining overall weightings of industry groups similar to those of the S&P 500”, according to its latest fact sheet of S&P Global.

The S&P 500, of course, is the standard market-cap-weighted stock index and serves as a benchmark for many index funds.

The S&P 500 ESG Index Fact Sheet refers to the S&P 500 as its “benchmark” and compares its price performance to the S&P 500. Eight of the top 10 stocks in the S&P 500 ESG Index are also among the Top 10 of the S&P 500. In fact, the same four companies – Apple, Microsoft, Amazon and NVIDIA – in the same order, are listed as the top four holdings of each.

Since the SPDR S&P 500 ESG ETF tracks an ESG index, which itself tracks a market index, it should be interesting to know if the ESG index has a higher ESG score than the S&P benchmark. 500. The ESG designation, after all, is the main distinction between the two indices. However, the fact sheets did not include the ESG scores of these funds.

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So to approximate their ESG scores, we took the top 10 stocks from each and manually calculated a capitalization-weighted score using each company’s publicly available ESG ratings from MSCI and Sustainalytics.

We averaged the results of the two rating agencies and found that the S&P 500 ESG Index had a capitalization-weighted ESG score 6.0% higher than the S&P 500.

ESG scores: ESG indices vs market indices

Chart showing ESG scores: ESG indices versus market indices

We repeated this exercise with 19 other popular ESG indices. In each case, we checked that the ESG index compared its performance to a traditional market index and calculated the ESG “upside” relative to the benchmark based on the top 10 holdings of each index.

Admittedly, the top 10 holdings are an imperfect approximation of the overall index, but the companies in question represent on average 25% and 31% of the total capitalization of equity indices and ESG indices, respectively. Additionally, ESG index creators would presumably want to choose companies with the highest ESG ratings for their largest holdings, provided this does not create too large a tracking error relative to the benchmark. Such a selection process would further increase the apparent improvement in the ESG criteria of the ESG Index relative to its main market benchmark.

ESG index Improvement of the ESG score compared to the market index

Graph illustrating the improvement in the ESG score of the ESG index compared to the market index

Our main finding, however, is that ESG indices generally only had slightly higher ESG scores than their parent market indices. Some ESG indices had even less ESG value since their capitalization-weighted scores were lower than those of their parent.

While the range of variation between ESG indices and market variation was wide, from -26% to +43%, most deltas were in the 0-10% band with an overall average of 8.3% .

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Whether the narrow margins of ESG score improvements are material or not is a question for investors in each fund. But if investors don’t have that information, they can’t answer the question.

Investors pay 40% higher fees on average for sustainable funds than for non-ESG funds. But according to our research, if investors think higher fees buy much higher ESG scores, they should think again.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / george tsartsianidis

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Brad Swanson

Brad Swanson is an impact fund manager and assistant professor of finance at George Mason University with an MBA from Columbia University.

Tristan Snyder

Tristan Snyder is a senior finance major at George Mason University. He previously served in the United States Navy.

Huxley Waitt

Huxley Waitt is a senior in George Mason University’s Financial Planning and Wealth Management program and a teaching assistant in finance.

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