Gaming ESG fund performance to attract assets

By LARRY SWEDROE

Although investment returns are important to investors, interest in environmental, social and governance (ESG) strategies has been on the rise. That interest has been accompanied by a boom in funds catering to the demand. In June 2013, there were 33 ESG funds, accounting for only 2.6 percent of all funds and 0.8 percent of the total assets under management (AUM). By the end of 2020, there were 138 funds (11.5 percent of all funds) with ESG investment strategies, with a combined AUM of $366 billion. In other words, assets of ESG funds had increased by about 22 times in just eight years.

Shangchen Li, Hongxun Ruan, Sheridan Titman and Haotian Xiang contribute to the sustainable investing literature with their April 2022 study ESG Spillovers in which they examined a sample of U.S. mutual fund families that introduced new active ESG equity funds over the period 2013-2020. They began by noting that 60 percent of the ESG mutual funds introduced after 2013 were managed by teams that also managed non-ESG funds.

The focus of their study was on the new ESG funds and their existing non-ESG “sibling” funds, which were managing $425 billion at the end of 2020. Fund data was from Morningstar; the ESG scores of individual stocks were from MSCI ESG Research; and Fama-French factor returns were from Ken French’s website. Alphas were measured against the Carhart four-factor model (beta, size, value and momentum). Following is a summary of their key findings:

The average ESG score of ESG funds was significantly higher than that of standalone non-ESG funds, while the average ESG score of sibling funds was between the two.
There was not a significant difference in the fees of ESG and non-ESG funds.
There was not a significant difference in funds’ average exposures to the Carhart factors of market, size, value and momentum — factors that explain the vast majority of the variation in performance of diversified portfolios.
There was no significant difference in either ESG scores or performance of co-managed ESG and standalone ESG funds.
When non-ESG managers started to manage ESG funds, the average ESG scores of their non-ESG funds increased—co-managed, non-ESG funds increased their holdings of high-scoring ESG stocks, and the difference in scores increased with the duration of co-management.
Despite being less constrained, co-managed non-ESG funds underperformed their ESG sibling funds—the average difference in alpha between co-managed non-ESG and ESG funds was close to 1 percent per annum.
Mutual fund families have an incentive to shift performance from non-ESG to ESG funds to attract inflows. They do so by trading illiquid stocks prior to their non-ESG siblings, and they get preferential IPO allocations; the ratio of offering to total net assets per deal for ESG funds is about four times as large as that for their siblings.
ESG funds tend to be allocated shares in better quality IPOs—first-day returns of IPOs allocated to ESG funds tended to be more underpriced than those allocated to their non-ESG siblings. About 35 basis points of the yearly excess performance of ESG funds came from IPOs, significantly higher than the contribution of IPOs to the performance of non-ESG sibling funds.
The performances of ESG and standalone non-ESG funds were not significantly different—sibling funds underperformed both their ESG siblings and standalone non-ESG funds.

Surprising finding

One surprising finding was that the flows for ESG funds were more sensitive to positive alphas than their sibling funds, although there was no difference in the sensitivities of their flows to negative performance. When ESG funds generated 1 percent alpha, they attracted $8.5 million of net inflow, but for sibling non-ESG funds, this effect was only $0.38 million. My expectation would have been that because ESG investors are more focused on expressing their values, they would be less sensitive to alphas (either positive or negative). Their finding that ESG investors were in fact more sensitive to positive alphas provides incentive for investment firms to manipulate returns in favor of their ESG funds in order to try to improve their performance.

Their findings led Li, Ruan, Titman and Xiang to conclude that the initiation of an ESG fund creates a negative spillover effect on the non-ESG funds managed by the team.

Investor takeaways

Investment management firms have long played games to try to induce fund flows. For example: A fund family with an active small-cap growth strategy with large dollars of AUM launches a new active small-cap growth fund, which will have a small amount of AUM. It then allows the new small-cap fund to front-run the existing fund when it trades in the same illiquid stocks, and it assigns a large allocation of “hot” IPOs to the new fund. Given the differences in AUM, the positive impact on the returns of the new fund will be proportionally much greater than the negative impact on the older fund. In other words, there is nothing new going on, just investment management firms trying to pull the wool over investors’ eyes, favouring one group of investors over another in an attempt to drive cash flows and earn greater fees. Given that Li, Ruan, Titman and Xiang found that the average size of ESG funds was only about one-third of that of their sibling non-ESG funds, fund sponsors are incentivised to favor the smaller ESG funds in their trades and IPO allocations—the positive impact on the returns of the ESG funds will be relatively larger than the negative impact on the non-ESG funds because they have more assets to spread across the negative impact.

Finally, as Li, Ruan, Titman and Xiang noted: “Mutual funds are required to act in the best interest of their clients by the fiduciary duties of care and loyalty under Section 206(1) and (2) of the Investment Advisers Act of 1940. From the perspective of the clients of sibling non-ESG funds, the transfer of performance is a violation of these rules.”

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