ESG Has Failed to Outperform for Years. Is this a Fix?

Investors in ESG mutual funds have lagged the benchmark and haven’t been protected on the downside. Quants say there’s a better way.

Illustration by II

Illustration by II

Investors who avoid the stocks of the biggest polluting companies or those with no women in their senior ranks do about as well as a passive index fund.

That’s a problem when funds that invest according to environmental, social and governance goals are one of the fastest growing areas in asset management. These strategies have historically failed to provide better performance or risk management than index funds that invest in every company in the benchmark, regardless of whether it produces fossil fuels or guns.

Some asset managers say quantitative techniques that have long been used in hedge funds can be used to improve these investments.

Basil Williams, chief executive officer of quant firm Welton Investment Partners who co-founded multi-strategy relative value firm Concordia Advisors in 1994, said by phone that quants are well positioned to both integrate independent sources of valuable ESG data in investment processes and use techniques such as machine learning, artificial intelligence, and other big data strategies to uncover information about a company and react quickly within portfolios. Welton offers quantitative global macro, equity statistical arbitrage, and systematic trend strategies, as well as multi-strategy and customized investments.

The median annualized return between 2010 and 2019 of ESG equity funds with a track record of at least 10 years and $100 million in assets was 11.98 percent, according to data from eVestment and Morningstar. The Standard & Poor’s 500 index returned 13.56 percent annualized during the period. All ESG funds returned 10.84 percent. The total funds analyzed represented 72 percent of Morningstar’s $137.3 billion in total sustainable mutual fund and ETF assets at the end of 2019.

ESG funds not only trail benchmarks, but also exhibit nearly identical volatility as the index itself. That means investors’ ESG funds aren’t protecting them from market drawdowns, even though managers of ESG funds often claim that environmental and social screens can help them avoid stocks that pose the biggest financial risks. From 2010 to 2019, the MSCI KLD 400 Social Index had a return-to-volatility ratio of 1.01, while the same volatility measure for the S&P 500 was an almost-identical 1.09, according to Welton.


Williams, who is the former co-chief investment officer at Mariner Investment Group, said Welton is launching a strategy on June 1 that will integrate new ESG data and tools with the firm’s legacy quant strategies to offer an outcome-oriented ESG product for investors.

“We’ll take our quant engines and bring in third-party scoring data,” said Williams. He explained that the firm will also use natural language processing and artificial intelligence techniques to scan tens of thousands of media and other reports, and integrate the information into a scoring framework. “The bottom line is that in addition to mitigating idiosyncratic risk by eliminating those companies who score in the bottom one-third of the universe, we work to address the systemic risk using our quantitative models to both modulate market exposure and integrate orthogonal [uncorrelated] strategies that can protect a portfolio in periods of economic contraction,” he said.

Welton isn’t offering something new so much as combining what it already does with a new investment objective. An ESG strategy is part of a larger objective by the firm to offer more outcome-oriented products. “I’m not coming in and redesigning the Lego parts. I’m just redesigning how they’re implemented. In the mainstream world of asset management, I’ve rarely seen these combinations in a single portfolio,” he said. Welton’s core strategy was up about 13 percent this year through the first quarter, according to eVestment.

[II Deep Dive: AQR: Here’s What ESG Really Does to Portfolios]

Many allocators and asset managers that invest with ESG mandates say their goal is two-fold. They want to invest in companies with a better track record in areas such as climate change and diversity. But they also expect market-rate returns and better risk management because they are avoiding stocks with long-term risk factors, like those that are harming the environment.

Traditional fundamental active managers have so far dominated ESG, arguing that their hands-on research process is well suited to root out nuanced ESG issues.

But quants and hedge funds are slowly entering the ESG market. In 2017, quantitative firm Acadian Asset Management launched the first actively-managed emerging markets strategy that was free of companies that own fossil fuel reserves. It has since offered others, arguing that quants can swiftly analyze thousands of stocks based on different factors. Last year, Atlas Impact Partners, whose founders included David Lowish, a former partner at Generation Investment Management and Just Capital’s Rob Brown, launched one of the first impact investment-themed long-short hedge funds. The hedge fund invests in companies developing solutions for environmental and social problems, while betting against the stocks of businesses seen as damaging to the world.