December 9, 2021 | Expert Perspective

Is there a performance price for ESG investing?

Jan-Carl Plagge, Senior investment strategist

Jan-Carl Plagge
Senior investment strategist

Doug Grim, Senior investment strategist

Doug Grim
Senior investment strategist

The demand for Investment strategies with an environmental, social, and governance (ESG) dimension continues to accelerate. This has led to ESG becoming the topic of many of your client conversations.

As investor appetite for ESG increases, clients may wonder how such a shift to ESG investments will impact their risk and return expectations. Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds (PDF), a research paper published by Vanguard Investment Strategy Group's Jan-Carl Plagge and Doug Grim in The Journal of Portfolio Management examines whether ESG equity fund strategies come with a cost in the form of lower expected returns, higher volatility, or both.

ESG fund performance varies

Mr. Plagge and Mr. Grim looked at ESG mutual funds and ETFs focused on U.S.-listed stocks and investigated differences in their gross returns and volatility (standard deviation of returns) over a 15-year period compared with the FTSE USA All Cap Index. They distinguished between index and active funds and between funds that apply explicit exclusions and those that do not. Dividing the sample period into three five-year periods, they found a high level of dispersion for both risk and return among ESG strategies. (See chart below.)

"We found funds with higher returns and higher risk, lower returns and lower risk, higher returns and lower risk, and lower returns and higher risk than their investment universe," Mr. Grim said. "Overall, our findings suggest that ESG funds have neither systematically higher nor systematically lower raw returns or risk than the broader market."

ESG funds produce mixed risk and return results versus the broad market

In the example above, there are two scatter plot charts comparing the volatility difference to the return difference as it relates to ESG funds. The left side shows a larger cluster of blue dots representing active ESG funds with greater concentration in the greater return, higher volatility quadrants. The fewer gray index fund dots are tightly clustered around the center point of the four quadrants. The right side scatter chart compares funds with ESG exclusions to those with no exclusions. Both data sets are clustered around the same area primarily in the higher volatility higher returns quadrants. The fact that both clusters overlay each other shows there is little meaningful differences found between funds with ESG exclusions and those without when it comes to performance.

Notes: The data points reflect the annualized five-year standard deviation and gross return of each fund minus the broad U.S. equity market as proxied by the FTSE USA All Cap Index. ESG fund categories include index funds, active funds, exclusion based, and nonexclusion based. The figures include data of three five-year periods: January 2004 to December 2008, January 2009 to December 2013, and January 2014 to December 2018. The numerical values in each quadrant represent the share (%) and number (x) of ESG funds—time period combinations in each category that fall into the respective quadrant. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment because one cannot invest directly in an index.

Source: Authors’ calculation based on data from Morningstar, Inc.

© 2020 Pageant Media. Republished with permission of PMR Journal of Portfolio Management. Have investors paid a performance price? Examining the behavior of ESG equity funds, Vol 46, Issue 3 Ethical Investing 2020. For more information, please visit All rights reserved.

Do ESG funds deliver alpha?

The authors then tried to identify potential alpha across these strategies. To control for factor tilts, they evaluated the performance of ESG strategies against that of each of the factors in the Fama-French five factor model: market, size, valuation (value/growth), profitability (quality), and capital investment.

The market factor proved, as one would expect, highly significant across the entire fund universe. The influence of style factors, on the other hand, was much less consistent. Some ESG funds had statistically significant and positive exposures to a given factor, while others had a significant but negative exposure to the same factor—and some had no noteworthy exposure to that factor at all.

Many of the funds performed quite differently compared with the market-capitalization-weighted U.S. equity market. "However, after controlling for the impact of known sources of risk—that is, market- and style-factor exposures—the majority of ESG funds did not produce statistically significant positive or negative gross alpha," Mr. Plagge said. "Return and risk differences of ESG funds can be significant, but they appear to be mainly driven by fund-specific criteria rather than a homogeneous ESG factor."

Because ESG funds often favor new technologies and avoid certain sectors, such as those relating to fossil fuels, the researchers were interested in the effects of such systematic deviations in industry exposures. Funds in the sample tended to be slightly underweighted in finance, energy, minerals, and consumer services and slightly overweighted in health and technology. However, the authors found the effects of these deviations on relative fund performance to be very small in median terms when sampled on a quarterly basis across the 15-year period with all funds observed.

Mr. Grim and Mr. Plagge then calculated net (after cost) alphas and analyzed their relationship to expense ratios. There was again a significant dispersion in the results (See chart below). Consistent with other research, higher expenses generally were associated with lower (or negative) net alphas.

Higher ESG fund management expenses tend to be associated with lower net alpha

In the example above, the scatter plot chart compares the alpha and cost of both index and active ESG products to find that higher costs are associated with lower net alpha. The average monthly expense ratio is the x-axis and the net alpha is plotted on the y-axis. There are a larger number of blue dots representing active funds than gray dots representing index. There is a greater dispersion of results with the blue dots but clearly showing that as you move across x-axis to higher costs the active funds plot lower returns. The gray dots of the ESG index funds are clustered around the lower end of the cost axis and the 0% net alpha line.

Notes: Relationship between net alpha and average over monthly expense ratios. Mostly expense ratios are calculated as the difference between gross and net returns. The exhibit includes data from the five-year periods: 2004 to 2008, 2009 to 2013, and from 2014 to 2018. Funds are those focused on U.S. equities using ESG as a factor in their investment process, as identified by Morningstar. Benchmark is FTSE USA Equity All Cap.

Sources: Vanguard calculations based on data from Morningstar, Inc.

© 2020 Pageant Media. Republished with permission of PMR Journal of Portfolio Management. Have investors paid a performance price?  Examining the behavior of ESG equity funds, Vol 46, Issue 3 Ethical Investing 2020. For more information, please visit All rights reserved.


The key takeaway: There is a lot of variability in the way ESG strategies perform. "Given these differences in risk-return outcomes and the high degree of heterogeneity in the construction and management of ESG funds," Mr. Grim said, "investors should assess potential investment implications on a strategy-by-strategy basis."


  • All investing is subject to risk, including the possible loss of the money you invest.
  • ESG funds are subject to ESG investment risk, which is the chance that the stocks or bonds screened by the index provider for ESG criteria generally will underperform the market as a whole or, in the aggregate, will trail returns of other funds screened for ESG criteria. The index provider's assessment of a company, based on the company's level of involvement in a particular industry or the index provider's own ESG criteria, may differ from that of other funds or of the advisor's or an investor's assessment of such company. As a result, the companies deemed eligible by the index provider may not reflect the beliefs and values of any particular investor and may not exhibit positive or favorable ESG characteristics. The evaluation of companies for ESG screening or integration is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the screens will depend on the index provider's proper identification and analysis of ESG data.
  • Figures are as they appear in The Journal of Portfolio Management.