Fund selection risk a material issue

Investors face fund selection risk and a substantial disparity in performance when choosing sustainable investment strategies, especially when it comes to ESG exchange-traded funds (ETFs).

The difference in annualised returns between ESG funds can be as high as 6.5% over a six-year period, when adjusting for differences in market exposure.

Even when variations in industry exposure are accounted for, the different remains high at 4.9%.

Over a one-year period, the difference can reach as high as 22.5% for returns adjusted for market exposures, and 25.3% for industry-adjusted returns.

The data is the latest release from Scientific Beta, the global index solutions provider that focuses on smart factor, ESG and climate.

Scientific Beta is a subsidiary of the Singapore Exchange (SGX) and partners with École des Hautes Etudes Commerciales du Nord (EDHEC) Business School to inform its research.

Scientific Beta research director, co-author on the study Felix Goltz, commented: "ESG fund returns largely depend on fund-specific choices of how to integrate ESG information. This suggests that ESG investors face substantial fund selection risk. Importantly, traditional fund selection strategies like relying on past performance or tracking error are inadequate for predicting future ESG fund performance.

"Our evidence emphasises that inconsistencies in ESG approaches contribute to significant dispersion in the performance of ESG investment products. Investors need to be aware that fund selection risk is a material issue for sustainable investment strategies."

Large disparities in performance create fresh concerns for product providers, Goltz conceded.

"Dispersion in performance allows ETF providers to always present investors some strategy that has recently outperformed. The evidence from the literature on funds' flows suggests that investors are particularly sensitive to recent performance," Goltz said.

"This issue is aggravated by the fact that there is no consensus on the definition of ESG, which gives ETF providers a license to come up with new products that replicate ESG approaches that have recently outperformed. It remains to be seen whether the industry will move towards harmonisation of ESG definitions and practices, a shift that would reduce divergence and ultimately returns dispersion.

"Our empirical results suggest that the current confusion of ESG practices translates into return dispersion that in turn creates risk for those investors who select among different ESG investing products. In other words, fund selection risk is a material ESG issue."

Read more: Scientific BetaFelix GoltzEDHEC Business School