How Well Has Environmental, Social, and Governance Investing Performed?

Environmental, Social, and Governance investing (ESG) holds some emotional appeal for many investors. Having alignment between your investments and your personal values sounds good, but it is natural to ask if there's a downside to ESG. Do you have to accept poor returns from your investments if you want them to be socially responsible? Is ESG riskier than non-ESG approaches? Our research has found otherwise: ESG has tended to perform very similarly and with very similar levels of risk to non-ESG approaches.

As you may know, there is no single definition of ESG. For research purposes, we looked at mutual funds that Morningstar flags as "Sustainable Investment – Overall" as our ESG universe. This was a group of 222 unique funds across a range of categories, with most of the funds in U.S. Equity and International Equity asset classes.

In this group, Morningstar includes funds with a variety of approaches, but excludes funds it sees as "ESG Consideration" only. This means that it aims to include only those funds for which ESG principles are an important part of the investment process, not funds that mention ESG issues in their paperwork but that don't meaningfully rely on ESG.

One way to measure the performance of ESG funds is to see how their performance ranks relative to funds in the same Morningstar category. A fund that ranks in the 1st percentile for a three-year period has done better than all of the other funds like it over that time, while a fund that ranks in the 100th percentile has done the worst of all of its peers. If ESG funds were systematically at a disadvantage thanks to sticking to ESG principles, they would rank between the 50th and 100th percentiles time after time.

Instead, what you can see from the chart above is that on an overall basis and across the three largest asset classes, ESG funds have consistently ranked around the middle of their peer groups—sometimes a bit below the middle, sometimes a bit above, but never dramatically worse. If ESG funds were at a natural disadvantage, these lines would be toward the bottom of the chart. If anything, ESG funds have done a bit better than average overall, especially recently (though this isn't a strong effect).

When it comes to the risk of an investment portfolio like a mutual fund, one common measure is the standard deviation of returns. The higher the standard deviation, the bigger the swings the fund has experienced, both up and down. Stocks, for instance, tend to have much higher standard deviations than bonds.

The table below shows standard deviations for ESG funds compared to their Morningstar category peers for the 10 categories that have the most ESG assets.

While there are a lot of numbers in the table above, the important numbers are the "Difference" rows in each section. If the difference is negative, it means the ESG funds in the category had a lower standard deviation—that is, less risk—than the peer group. A positive difference means that ESG funds were riskier than peers. If the difference is larger than half a percent, it is colored green (when ESG funds had lower risk) or red (when ESG funds had higher risk). There's some red on the table (particularly in Mid Cap Growth and Large Value) and some green on the table (particularly in Mid Cap Blend), but overall little color, which means that over the past one-, three-, five- and 10-year periods, there wasn't any strong evidence for ESG funds being riskier than other funds.

Because environmental, social and governmental strategies exclude some securities, ESG-focused products may not be able to take advantage of the same opportunities or market trends as products that do not use such strategies. Additionally, the criteria used to select companies for investment may result in investing in securities, industries or sectors that underperform the market as a whole.

Many investors care first and foremost about how a fund will do when times get hard and the market drops in value. So, how have ESG funds held up when stock markets have dropped in value?

The table below shows the performance of ESG funds compared to their Morningstar category averages during the last six corrections (a drop of 10% in the stock market) and two bear markets (a drop of more than 20%). The most important rows here again are the differences, with green numbers showing times and categories where ESG funds held up better than their peers by at least half a percent, and red numbers showing where ESG funds held up worse by at least half a percent.

As with the risk table, you can once again see more green than red, indicating that ESG funds dropped less than their peers more frequently than they dropped farther. The two actual bear markets in the table—the first column, showing the 2020 coronavirus pandemic, and the last column, showing the 2008 great financial crisis—have only a single red number between them. This doesn't mean that ESG protected investors from losses during market declines; in fact, ESG funds still fell substantially in value during those times. But they didn't have any pattern of falling any more than other funds, and they often fell less.

While the results from these time periods have been generally encouraging for ESG funds as a whole, we don't see convincing evidence that ESG funds are reliably better than non-ESG funds. The differences have tended to be small, and even when the differences have been good for ESG funds, there were always some individual funds that did worse. The important lesson here is that there is no evidence that choosing ESG funds puts investors at any kind of disadvantage when it comes to risk or returns.

Bottom line: If the concept of socially responsible investing appeals to you, our research has found that you should not have to reduce your expectations when it comes to risk and return. ESG funds have done as well as other funds over time. However, there are many ESG options available and multiple ways to build an ESG portfolio. You should take into account your investment goals and risk tolerance before getting started in ESG investing.