Sustainable Investing Research Suggests No Performance Penalty
Review of academic studies show sustainable/responsible funds perform on par with conventional funds.
We know there is a lot of interest in sustainable investing today, particularly among emerging investor groups like women and millennials, who, by some estimates, will soon control upwards of $30 trillion in assets as they amass wealth through earnings and inheritance.
For high levels of interest in sustainable investing to translate into actual investments, financial intermediaries need to step in to help their clients incorporate sustainability into their portfolios. For advisors, planners, and retirement plan fiduciaries, one of the biggest obstacles to sustainable investing is the lingering perception that it has a negative effect on investment performance.
I just completed a review of academic research on the topic and found that the research strongly suggests that there is no performance penalty associated with sustainable investing.
Dozens of studies have been published over the past 15 years addressing the performance question, with researchers studying different time periods, regions, and asset classes and measuring performance in gross, net, and risk-adjusted terms. To be sure, the findings are varied, but when the evidence is accumulated, the vast majority of studies report neutral or mixed outcomes. There are much smaller numbers of clear-cut positive or negative results, although positive outcomes are more frequent than negative outcomes.
The following two charts provide compelling evidence that’s consistent with the research findings. The first shows the performance of the oldest sustainable/responsible index, the MSCI KLD 400 Index, formerly called the Domini 400 Social Index) compared with the S&P 500.
Exhibit 1: MSCI KLD 400 Index versus S&P 500
- source: Morningstar Direct.
From its 1990 inception through September 2016, the MSCI KLD 400 has actually outperformed the S&P 500 by 81 basis points annualized. Although much of that outperformance occurred during the 1990s, the KLD index has outperformed by 27 basis points annualized over the trailing 10 years, through September.
The second chart shows the cumulative Morningstar Analyst Rating of all funds tagged in our global database as having a “socially conscious” mandate between 2002 and 2016. I included the year-end star rating of every share class as of the end of each calendar year (and used September data for 2016). To avoid biasing the data in favor of surviving--and likely more successful--funds, the data include funds that have since been liquidated or merged away.
- source: Morningstar Direct.
During that time span, we observe a distribution of Morningstar ratings among socially conscious mutual funds that is similar to that of the overall fund universe. The socially conscious funds cluster slightly more toward the middle (2, 3, and 4 stars) than does the overall universe. It is worth noting, also, the slight positive skew to the star rating distribution of socially conscious funds: more 5-star (8.4%) than 1-star funds (7.1%) and more 4-star (25.1%) than 2-star (21.6%) funds. Thus, the star-ratings results are consistent with the research literature: Socially conscious funds have similar risk-adjusted performance that, if anything, skews positive relative to conventional funds.
While the research is clear that there is not a performance penalty associated with sustainable investing generally, there is some evidence that SRI exclusions, taken in isolation, can be a drag on performance. Few sustainable funds, however, limit themselves to the use of such screens. Most funds also use ESG inclusion--the evaluation of company sustainability based on environmental, social, and governance factors either through positive screening or integration of ESG considerations into the stock-selection process. And a growing body of research suggests that ESG inclusion can lead to positive performance outcomes. Thus, with most existing sustainable/responsible funds, the potentially negative effects from SRI exclusions can be offset by the potentially positive effects from using ESG inclusion to select stocks. This line of reasoning suggests that funds that eschew exclusionary screening altogether and rely instead solely on ESG factors may have the most potential to outperform.
For those interested in sustainable investing, the research suggests you can address your sustainability concerns in your portfolios while also receiving competitive performance. To be sure, there remain challenges to sustainable investing. The number of intentionally sustainable funds remains small compared with the overall universe (1% to 2% of funds globally), making it difficult to find funds to fill out a portfolio. (The Morningstar Sustainability Rating for funds can help you find additional funds that hold more-sustainable companies.) And even though such funds perform on par, if not a little better, than conventional funds, there is a range of manager skill and fund quality that investors must still discern when selecting funds, just as they have to do when they are working with the much-larger conventional universe. But there is no reason, based on the academic research on performance, to steer investors away from making sustainability a part of their portfolio.
Jon Hale has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.