When it comes to the latest investing trend, ESG funds, there is not much that differentiates them from index funds. You might be surprised to know that ESG funds have considerably higher fees – up to three times more expensive.
‘Green’ Funds Cost Three Times More Than You Think
Buying an ESG fund is a lot like buying in an index fund. That means investors are paying a lot for the small part that is different.
By Jason Zweig
You might not be able to do well by doing good, but you will certainly pay more to feel good.
Wall Street’s latest bandwagon—or juggernaut—is ESG investing, which seeks to make businesses and the world [E]nvironmentally cleaner, [S]ocially fairer and [G]overned better.
I doubt most people buying funds following this approach realize how much they are paying and how little they are getting. At the average ESG fund, the effective fees can be three times what’s reported, according to a new study. That’s because these funds—also often called green, sustainable or responsible—are nowhere near as pure as they purport to be.
Over the five years ended Dec. 31, investors added an estimated $64.6 billion to mutual funds and exchange-traded funds using ESG strategies to invest in U.S. stocks. Meanwhile, investors yanked $92.2 billion out of all other U.S. stock funds combined.
Although some ESG funds take conservative or even “biblically responsible” approaches that favor industrial and other old-fashioned sectors, most seek to avoid companies that emit excessive pollution, consume precious natural resources, squelch labor unions, downplay gender equality and so on.
The inevitable result: They tend to favor software and healthcare, while tilting away from oil and gas.
Sustainable U.S. stock funds have 22.1% of their assets in technology and 15.4% in healthcare, but only 2.6% in energy, according to Morningstar. Non-ESG funds, meanwhile, hold 18.7% in tech, 14.3% in healthcare and 5.7% in energy.
No wonder green funds outperformed over the past five years, earning an average of 8.1% annually, while non-sustainable funds grew at 6.9%. For most of that period, tech and healthcare boomed, while energy lagged.
Last year, however, tech went into the tank along with most of the market, while energy stocks were among the only winners. Green funds lost 19.7%, faring even worse than conventional funds, which fell 18.1%.
In 2015, an analysis of more than 2,000 research papers found striking results. Slightly more than half of studies on corporations showed that those adopting ESG principles improved their financial results. But only one in six studies on ESG funds found that these portfolios performed significantly better than average.
Maybe sustainable stocks get bid up to unsustainable prices, reducing the future returns of the funds that hold them. Maybe ESG funds are bad at picking “good” companies.
Or maybe green portfolios end up investing almost exactly like their non-ESG peers—incurring higher costs to do the same thing as funds that don’t pretend to wear a halo.
Look at the top holdings of most sustainable funds and you’ll see the same names: Apple Inc., Microsoft Corp., Google parent Alphabet Inc., UnitedHealth Group Inc., JPMorgan Chase & Co. These stocks are also among the largest in the S&P 500.
The average green U.S. stock ETF charges 0.17% in annual fees, according to Morningstar—0.05 percentage points more than conventional funds.
That doesn’t sound so bad until you triple it.
On average, according to a new Harvard study, ESG funds have 68% of their assets invested in “the exact same” holdings as non-ESG funds.
So, for every dollar you invest in a responsible fund, only about 30 cents goes into stocks you couldn’t have gotten in a fund that makes no show of trying to make the world a better place.
Although only about a third of your money in the average ESG fund is distinctly “green,” you incur the fees on the entire portfolio. Therefore, “you’re really paying three times as much for the thing you care about, the differentiated piece of the portfolio,” says one of the study’s authors, finance professor Malcolm Baker of Harvard Business School.
Nearly all the variation in returns of conventional U.S. stock funds can be explained by the fluctuations of the S&P 500, according to Morningstar. On a statistical measure of similarity called the R-squared, their average score is 0.95.
At green funds, the average R-squared relative to the S&P 500 is 0.98.
Responsible portfolios aren’t less like the overall market than traditional funds. They are even more like it.
That’s partly because non-ESG funds tend to own smaller stocks. But with green funds, on average, acting 98% like the mainstream stock market, you’re kidding yourself if you think they’re a distinctly different way to invest.
Asset managers love ESG because it generates fat fees and because the money is “sticky.” If you’re buying a fund because you think it will help save the world, you’re more likely to stay put even if the returns are subpar.
As my colleague James Mackintosh explained in a series last year, you don’t punish “bad” companies by avoiding their stocks or reward “good” ones by buying theirs. Somebody else will still own the shares you sell or shun, while sky-high stock prices are no incentive to better corporate decision-making.
If, despite all this, owning an ESG fund still makes you feel you’re on the side of the angels, I suppose that warm glow could be worth paying for—much as an expensive watch or car might make you feel special. Just make sure you understand the price you’re paying could be triple what it says on the label.
Source: The Wall Street Journal February 3rd, 2023