Date: 5th September 2022
Author: BETTER FINANCE

An analysis by ESMA, the European Securities and Markets Authority, has shed light on the costs and performance of Environmental, Social, and Governance (ESG) funds compared to non-ESG funds. The findings reveal that ESG funds have lower costs and better performance, even after considering factors such as portfolio composition. Understanding the drivers behind these differences is crucial for the fund industry and can contribute to making investment funds more affordable and profitable for retail investors.

The analysis focused on several factors to explain the cost and performance differentials between ESG and non-ESG funds:

  • Size of Underlying Issuers: ESG funds tend to have higher exposure to large-cap firms, which can lead to lower trading costs due to higher liquidity. ESG ratings may be biased towards larger companies that provide more ESG disclosures.
  • Geographical Exposure: ESG funds have shifted their focus towards developed economies, while non-ESG funds increased exposure to North America and Asia. Investing in emerging markets may involve higher costs, such as currency hedging.
  • Sectoral Exposures: ESG funds increased their exposure to healthcare stocks, which performed well during the COVID-19 crisis. Both ESG and non-ESG funds reduced exposure to consumer defensive, energy, and financial stocks, with ESG funds showing a greater reduction.
  • Portfolio Characteristics: Factors such as fund age, size, management style, and target clients impact costs. ESG funds were associated with lower costs, while older funds and fund-of-funds had higher costs.

ESG funds have shown to be cheaper and perform better than non-ESG funds, even after accounting for portfolio composition. Factors such as size, geographical exposure, and sectoral allocations play a role in these differences.

ESG funds have greater exposure to large-cap stocks and developed economies, which correlates with lower ongoing costs. The analysis also reaffirms previous findings that funds targeting institutional clients, passive funds, and more recent funds are associated with lower costs. Moreover, funds created as ESG funds tend to have lower fees compared to funds that converted to ESG later. Impact funds are also cheaper than ESG funds employing other ESG strategies.

While ESG funds have higher exposure to sectors such as healthcare and technology, these sectoral differences alone do not explain the outperformance of ESG funds. Interestingly, funds focusing on the social (S) or governance (G) pillars outperformed non-ESG funds, while funds focusing on the environmental (E) pillar did not show a significant outperformance. This finding challenges conventional expectations and suggests that considering social and governance factors alongside environmental ones can drive better performance.

The findings support the potential benefits of ESG investing and emphasise the importance of clear information for investors to make informed decisions. Understanding the costs and performance of ESG funds is crucial for investor protection given the growing interest in investment fund costs and performance, particularly in the expanding ESG market.

Further research is needed to fully understand the reasons behind the relative cost-effectiveness and outperformance of ESG funds. Exploring additional factors such as total costs, environmental/social performance, and risk-adjusted performance would provide more comprehensive insights.

By implementing a transparent methodology using a standardised set of ESG rating metrics and ensuring a better comprehension of the drivers of cost and performance in ESG funds, fund providers can offer the necessary clarity to retail investors and improve their understanding of ESG products. This, in turn, will encourage competition among available ESG products and lead to competitive pricing for end-users.

➡️ Read the ESMA Report on “The drivers of the costs and performance of ESG funds” here.