The Surprising Risks of Investing in ESG Funds – The Wall Street Journal

The Surprising Risks of Investing in ESG Funds The Wall Street JournalThe Surprising Risks of Investing in ESG Funds The Wall Street JournalThe Surprising Risks of Investing in ESG Funds The Wall Street Journal

Recent research has shown that ESG funds are more susceptible to oil price changes than the S&P 500. This is despite the fact that most ESG funds do not hold oil-and gas stocks. Photo by Carlos Barria/Reuters September 16, 2021 at 1:00 PM ET. What risk are you taking as an ESG investor. You might be surprised at the answer. Funds that have to avoid certain stocks or sectors because of environmental, social, or governance (ESG), tend to be overweight in other stocks and sectors. Investors could be exposed to risks they don’t expect. My research revealed that ESG investors may be more at risk of small-cap, interest-rate, inflation, and single stock risk than those who invest in standard equity funds. Beau Fitzpatrick, a research assistant from George Mason University, and myself compiled a list U.S.-based Equity funds from Morningstar Inc. with the words “ESG,” or “Sustainable”, in their names. We then reviewed each entry to create a comprehensive and accurate U.S. ESG equity fund list (which was then cross-checked against the Forum for Sustainable and Responsible Investment’s list of ESG funds). Next, we examine the fund’s monthly returns over the past twenty years and the correlation between those returns and various factors that can affect asset prices such as short-term interest rate, inflation, and oil prices. We also did the same with the S&P 500, examining how their returns correlated with those same factors over that same period. Finally, we compared the results to the ESG funds. Worth the risk?
ESG-focused funds tend to be more exposed to tech stocks and other volatile stocks than others. Comparing ESG funds’ correlation with several factors to the broad S&P 500’s.

Correlation is a statistical measure that measures how securities move relative to each other. A correlation coefficient of +1.0 indicates that the prices of the securities move 100% together. A coefficient of zero indicates that the fluctuations in prices are not related at all. No correlation ESG funds/S&P correlated with… ESG/Sustainable Funds 0.84 Russell 2000 (small-cap index) 0.841 0.231 Changes in oil prices 0.0.227 0.189 Changes in inflation 0.171 0.0.262 Changes in interest rates 0.252 1 0.5 +1.0 Correlation coefficient The correlation coefficient is a statistical measure of the movement of securities in relation to one another. A correlation coefficient of +1.0 indicates that the prices of the securities move 100% together. A coefficient of zero indicates that the fluctuations in prices are not related at all. No correlation ESG funds/S&P correlated with… ESG/Sustainable Funds 0.84 Russell 2000 (small-cap index) 0.8541 0.8261 Technology index 0.856 0.2231 Change in oil prices 0.0.227 0.2262 Changes in interest rates 0.0.252 0 0.5 +1.0. Correlation coefficient This is a statistical measure of the movement of securities in relation to one another. A correlation coefficient of +1.0 indicates that the prices of the securities move 100% together. A coefficient of zero indicates that the fluctuations in prices are not related at all. No correlation ESG funds/S&P correlated with… ESG/Sustainable Funds Russell 2000 Small Cap Index 0.876 0.841 0.860 Technology index 0.8556 0.231 Changes in oil prices 0.227 0.189 Changes in inflation 0.171 0.262 0.252 0 Changes in interest rates 0.252 1 0.5 +1.0 Correlation coefficient A statistical measure of the movement of securities in relation to one another. A correlation coefficient of +1.0 indicates that the prices of the securities move 100% together. A coefficient of zero indicates that the fluctuations in prices are not related at all. No correlation ESG funds/S&P correlated with… ESG/Sustainable Funds 0.7876 Russell 2000 (small-cap index) S&P 500 0.8441 0.0.860 Technology index 0.8231 0.222 Change in oil prices 0.0.227 0.189 Changes in interest rates 0.0.252 0 0.5 +1.0. Correlation coefficient Correlation refers to the statistical measure of how securities change in relation to one another. A correlation coefficient of +1.0 indicates that the prices of the securities move 100% together. A coefficient of zero indicates that the fluctuations in prices are not related at all. No correlation ESG funds/S&P correlated with… ESG/Sustainable Funds 0.877 Russell 2000 (small-cap index) S&P 500 0.8441 0.8560 Technology index 0.8556 0.2231 Change in oil prices 0.0.227 0.2262 Changes in interest rates 0.0.252 0 0.5 +1.0 Note: A correlation coefficient may also be extended to -1.0. This means that prices move in opposite directions 100% of the time.

Source: Derek Horstmeyer, George Mason University

ESG funds are, on average, more closely related to changes in interest rates than the S&P 500. This could be partly due to ESG funds’ excessive exposure to the tech sector. Many tech companies expect that the majority of their cash flow will come in the future. This makes them more sensitive to interest rate changes than other sectors. Our analysis shows that the average ESG fund has nearly 30% weighting in the tech sector, compared to 27% for S&P 500 index. Our analysis also revealed that more than one-quarter of 15 ESG funds have a greater than 40% weighting in tech, which is a significant concentration of risk in one sector in the U.S. economy. Another surprising result is that ESG funds are more exposed to oil price changes than the S&P 500. This is despite the fact that most ESG funds do not hold oil-and gas stocks. ESG funds tend to be more heavily geared toward cyclical industries like tech and consumer goods. This could be explained by changing oil prices. SHARE YOUR THOUGHTS Join the conversation below. The average ESG fund also has more total risk. Our analysis revealed that ESG funds had an average volatility of 15.46% per year over the past 20-years, compared to 15.04% for S&P 500. The greater volatility could be due the higher small-cap risk that average ESG funds take on. The average correlation between Russell 2000 (small-cap index) and an ESG Fund is 0.876. Over the past 20 years, the correlation between Russell 2000 with the S&P 500 was 0.841. ESG investors should also be aware of single-stock risk. One in ten of the ESG funds we examined had a holding with a minimum of 10%. It is a risky practice to place too much weight on one fund holding. Before investing in an ESG fund, investors should be aware of these risks. Unwelcome surprises could be the result of not looking under the hood when investing in ESG funds. Dr. Horstmeyer, a professor of finance at George Mason University’s Business School in Fairfax (Va.), is available for reports@wsj.com. Copyright (C.2021 Dow Jones & Company, Inc. 87990cbe856818d5eddac44c7b1cdeb8

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