ESG funds have outperformed over three and five years

Growth shares having the upper hand over value has been a tailwind for ethical funds.

Environmental, social and governance (ESG) funds have generally outperformed ‘conventional’ funds over both three and five years, according to the first edition of Refinitiv Lipper’s new quarterly report Everything Green Flows.

The report took the top three selling sectors in the first three quarters of 2021: Global Equity, UK Equity and Mixed Asset GBP Balanced. They then compared the performance of both ESG and non-ESG funds in this category over one, three and five-year periods.

The results showed that over the past three and five years, ESG funds in all three sectors outperformed non-ESG funds by several basis points. In the global equity sector, ESG outperformed by almost 10 percentage points on a three-year basis. UK Equity saw outperformance of 15 percentage points on a five-year basis.

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However, over a shorter period of time it is a different story. On a one-year basis, ESG funds beat non-ESG funds in the global equity and mixed asset sector, however, only by a small margin. ESG global equity funds delivered a return of 23.3% compared to 23% for non-ESG funds. Similarly, less than half a percentage point stood between the performance of ESG and non-ESG funds in the mixed asset sector.

For UK equity funds, non-ESG funds were the clear winners, returning 31.1% compared to ESG funds’ 29.1%.

So, what are we to make of these results? For those claiming that ESG investing provides outperformance, such numbers will be welcome news. However, as the report points out, the returns may be driven by other factors.

As the report says: “How much of the three- and five-year ESG outperformance is due to the ESG terrain being skewed to growth stocks, which have significantly outperformed over the longer term, and how much is due to the existence of an ESG premium?”

A feature of equity markets over the past decade has been the consistent underperformance of value stocks and outperformance of growth stocks. There are many theories to explain this, from low interest rates to low economic growth rates resulting in investors paying a premium for growth. Either way, if ESG funds have been overweight growth stocks this will have boosted their performance.  

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This dynamic can also be seen in the one-year results. From November 2020 to around April 2021, value and cyclical shares rallied, outperforming growth stocks for the period. Since then, growth stocks have returned to favour. However, thanks to this stronger-than-usual performance (at least compared to the past decade) of value stocks, ESG and non-ESG funds experienced almost identical returns. Meanwhile, in the even more value stock-heavy UK market, non-ESG funds outperformed by several percentage points.

Of course, none of this is to say that ESG funds won’t outperform for reasons closer tied to environmental considerations in the future. One of the (many) premises of ESG investing is that climate change is such a pressing issue that the world will eventually shun companies that sell fossil fuels or that are heavy emitters. Therefore, you might want to own companies that do not rely on fossil fuels and are, therefore, better positioned for some sort of world heading to net zero. 

This may drive the performance of ESG compared to non-ESG funds in the future. But it is also important to keep in mind the many other aspects that affect financial assets in different ways, such as the broader macroeconomic environment, inflation and interest rates.