The most frequently asked questions about sustainable investing still relate to performance. In theory, when investors limit their investments for moral or ethical reasons, they risk underperformance because they are not selecting the most successful funds.
Individual investors, or "normal people", choose less-efficient portfolios for all kinds of reasons. Those who choose a less-efficient portfolio for ethical reasons receive emotional benefits that can offset the financial costs of not receiving the highest possible return.
But I think it can also make them better investors; more engaged, patient, and focused on the long term. More recently, as the field has become focused on incorporating environmental, social, and corporate governance, or ESG, the thinking behind the investment process and the performance expectations have changed.
More institutional investors and asset managers today believe that integrating ESG in an effective way can help reduce risk and uncover overlooked investment opportunities, improving performance. Last year, I reviewed the academic literature on the performance of sustainable portfolios and open-ended funds. I found that, on the whole, it suggested no performance penalty, even though much of the research focused on older funds that largely excluded investments such as tobacco.
US Sustainable Funds Lead the Way
More recent literature on sustainability and its financial impact on individual companies pointed more decisively to a positive relationship. So as more sustainable funds focus on ESG rather than just excluding investments, their performance will become even more competitive over time.
Against that backdrop, let's take a look at the performance of the current crop of US-based sustainable funds. I am using my list of open-ended funds and exchange-traded funds that that explicitly focus on sustainable investing, ESG, or related themes.
I excluded funds that use only a limited set of negative screens, such as tobacco, alcohol, and gambling, and purely faith-based funds because neither of these types of funds focuses on incorporating ESG into their investment processes. By the middle of the year, there were 187 open-end funds and ETFs in the US that practice sustainable investing.
Of these, 141 are open-end funds and 46 are ETFs - 76 have not yet reached their three-year anniversaries. Thirty-five funds were launched in 2016 and another dozen in the first half of 2017. Overall, these funds cover 36 different Morningstar Categories.
The Morningstar Rating for funds, or the star rating, measures a fund's risk-adjusted performance, including up to 10 years of a fund's history, relative to its category. The star rating is distributed normally within each category.
Sustainable funds sit alongside conventional funds in their categories. If we observe that the overall star rating distribution of sustainable funds is comparable with that of other available investments, then we would have additional evidence that there is no performance penalty associated with sustainable funds.
In addition to the 76 that have not reached their three-year anniversaries, 14 ETF sector funds do not have star ratings because they are in the catch-all "miscellaneous sector" category, leaving 97 sustainable funds with star ratings. I used the oldest share class of each fund in this analysis.
The distribution of star ratings among sustainable investing funds skews in a positive direction, suggesting better risk-adjusted performance than their peers. The funds cluster toward the middle, with two, three, and four stars, more than comparable funds, but 38.2% of sustainable funds have either four or five stars while only 22.7% have one or two stars. Based on the expected distributions, those numbers should be equal at approximately 33%.
We can't say too much about the performance of the newer sustainable investing funds, but judging from their returns so far, they appear to be holding their own relative to the older funds and relative to their category peers.
On average, the returns of funds less than three years old are in the top halves of their categories for the year to date, the previous year, and previous two years to the end of June. They also, on average, have category ranks for those periods equal to or better than those of the older group of sustainable funds.
Anything can happen between now and when these younger funds reach their three-year anniversaries in the next couple of years, but my expectation is that they will not hurt the performance of already established sustainable funds, they may even improve it.
The current positive skew in the star ratings of sustainable investing funds is another piece of evidence countering the underperformance myth. There is, of course, a range of manager skill and fund quality that investors still must discern when selecting sustainable funds. But the evidence suggests that those interested in investing in sustainable funds can receive competitive performance while also addressing their sustainability concerns.
