ESG Funds Delivered in 2021

When it comes to environmental, social and governance (ESG) funds, advisors are getting increasingly familiar with at least one client concern: Do these funds offer comparable (or better) performance than traditional broad market strategies?

Broadly speaking, the news was encouraging in 2021. Encouraging because more clients are inquiring ESG and sustainable investing strategies and because the universe of funds in these categories – along with socially responsible investing – is rapidly expanding.

To the point about the ongoing proliferation of ESG funds, Morningstar says there are currently just 13 diversified ESG funds trading in the U.S. dedicated to domestic large caps, making those funds relevant comparisons to the S&P 500 and Russell 1000 indexes.

For ESG-hungry clients, the good news is that the average return of those funds 29.2% last year, meaning those products beat basic S&P 500 exchange traded funds, which gained 28.7% in 2021, according to Morningstar data. The top two performers in the domestic large-cap ESG group each returned around 31.6%.

Not a One-Off

While past performance is never a guarantee of future returns, it's worth noting that the solid showings delivered by domestic large-cap ESG funds in 2021 wasn't the first time those products outperformed pure vanilla indexes.

“The picture looks even better over the trailing two years. Every one of the baker's dozen ESG index funds outperformed the S&P 500 during the 2020-21 period, and all finished comfortably in the category's top quartile,” says Morningstar analyst Jon Hale. “(The) iShares Core S&P 500 ETF (IVV) two-year return, by contrast, placed just outside the top quartile. I include the two-year comparisons because the period corresponds with the pandemic and several of the funds do not yet have three-year records.”

An interesting point about the funds evaluated by Morningstar is that most of the group aren't old. Many advisors (and some clients) look for three-, five-, even 10-year track records on funds, regardless of underlying strategy. Just eight of the funds highlighted by Morningstar are three years old or older, but it pays to remember that with ETFs, age is nothing but a number.

“Only eight of the 13 ESG index funds have three-year records, but again for this period, all of them outperformed the S&P 500 on an annualized basis, and all of them placed in the category's top quartile (in fact, all placed in the top 15% of the category),” adds Hale.

For the ESG funds with track records of at least five years, the picture is similarly bright. The six funds in that group of 13 that have been around five years or longer each beat the S&P 500 over that span.

As Hale notes, that out-performance accrued despite higher fees. The aforementioned IVV charges just 0.03% per year. Some basic beta ETFs charge even less than that. Domestic large-cap broad market ESG ETFs aren't expensive per se, but the group that beat IVV over the trailing five years have expense ratios ranging from 0.24% to 0.32%.

In other words, it's impressive to beat the an S&P 500 index fund when the fee gap is so pronounced.

Keeping Expectations in Check

The fact that ESG funds outperformed last year is also impressive when considering many of these funds are underweight energy stocks or have no exposure to that group and that was the best-performing group in the S&P 500 in 2021.

Likewise, many ESG ETFs are overweight technology, potentially making those funds vulnerable if that sector declines or underperforms. That is to say advisors should keep clients' ESG performance expectations in check.

“In sum, ESG index funds are perfectly good options for broad U.S. equity exposure and most of them charge reasonable fees. Investors should not expect these funds to outperform every year, but neither should they avoid them altogether in the outdated belief that funds that consider ESG factors cannot deliver competitive returns,” concludes Hale.

Related: ESG Ratings Are Going to Be in Spotlight This Year