The surprising risks of investing in ESG funds

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We analyzed the numbers and found that these funds are exposed to certain risks that many investors might not expect.

What type of risk do you take as an ESG investor?

The answer might surprise you.

When funds must avoid certain positions due to environmental, social or governance (ESG) factors, they therefore tend to overweight other stocks and sectors. This means that investors could be exposed to certain risks which they do not expect. Specifically, my research has found that the average ESG investor may take more risk from small caps, interest rates and inflation, and equity risks than an investor in an all-equity fund. standard.

To investigate this, Beau Fitzpatrick, a research assistant at George Mason University, and I compiled a list of American equity funds from Morningstar Inc. that had the words “ESG,” “” reviewed each. entry to build a complete and accurate list of U.S. ESG equity funds (which was then cross-checked with the Forum for Sustainable and Responsible Investment’s list of ESG funds) years and how those returns correlated to various factors known to affect the prices of assets, such as short-term interest rates, inflation rate, and oil prices over the same time period, and then compared the results to those of ESG funds.

We found that ESG funds, on average, are more closely correlated to changes in interest rates and the inflation rate than the S&P 500. This may be due, in part, to the overweighting of the average ESG fund to the sector. technological. Since many tech companies expect most of their cash flow to come in the future, they tend to be more sensitive to changes in interest rates than companies in other industries. The average ESG fund has a weighting of almost 30% in the technology sector compared to 27% for the S&P 500 index, according to our analysis. We also found that more than one in 15 ESG funds have a weighting of more than 40% in the technology industry, which represents a considerable concentrated risk in one sector of the US economy.

Another surprising finding is that the average ESG fund appears to be more heavily exposed to changes in oil prices than the S&P 500, even though most ESG funds do not hold oil and gas stocks. The likely explanation is that oil prices often reflect changing economic conditions around the world, and ESG funds are more heavily weighted in favor of cyclical industries such as tech and consumer goods.

When it comes to total risk, the average ESG fund also has more. The average volatility of ESG funds has been 15.46% per year over the past 20 years, compared to 15.04% for the S&P 500, according to our analysis. This higher overall volatility could be due to the higher risk of small caps that the average ESG fund takes: the average correlation between the Russell 2000 (small cap index) and an ESG fund is 0.876, while the correlation between Russell 2000 and the S&P 500 is 0.841 over the past 20 years.

Finally, the risk associated with individual stocks is another issue to watch out for as an ESG investor. For one in ten ESG funds we studied, the largest holdings in the fund had a weighting of 10% or more. There is considerable risk in concentrating so much weight on a single asset in a fund.

Investors should be aware of these risks before choosing an ESG fund. Not looking under the hood of an ESG investment could lead to unpleasant surprises.

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