Home >Mutual Funds >News >The surprising risks of investing in ESG funds

We ran the numbers and discovered that these funds are exposed to certain risks that many investors may not be expecting

What type of risk are you taking on as an ESG investor?

The answer might surprise you.

When funds have to avoid certain holdings due to environmental, social or governance (ESG) factors, they tend to overweight other stocks and sectors as a result. That means investors could be exposed to certain risks they aren’t expecting. More specifically, my research found that the average ESG investor may be taking on more small-cap risk, interest-rate and inflation risk, and single-stock risk than an investor in a standard all-equity fund.

To investigate this, Beau Fitzpatrick, a research assistant at George Mason University, and I compiled a list of U.S.-based equity funds from Morningstar Inc. that had the words “ESG," “Sustainable" or “Impact" in their names and then reviewed each entry to build a comprehensive 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). Next, we look at the funds’ monthly returns over the past 20 years and how those returns correlated to various factors known to affect asset prices, such as short-term interest rates, the rate of inflation and oil prices. We did the same for the S&P 500—examining how its returns correlated to those same factors over the same period—and then compared the results to those of the ESG funds.

We discovered that ESG funds, on average, are more closely correlated to changes in interest rates and the rate of inflation than the S&P 500. This may be due, in part, to the average ESG fund’s overweighting to the tech sector. Because many tech firms expect the bulk of their cash flow to come in the future, they tend to be more sensitive to interest-rate changes than companies in other sectors. The average ESG fund has a nearly 30% weighting to the tech sector versus 27% for the S&P 500 index, according to our analysis. We also found that more than one in 15 ESG funds has a more than 40% weighting in the tech industry, which represents considerable concentrated risk in one sector of the U.S. economy.

Another surprising finding is that the average ESG fund seems to be more heavily exposed to changes in oil prices than the S&P 500, even though most ESG funds don’t 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 toward cyclical industries such as tech and consumer goods.

As for total risk, the average ESG fund has more of that, too. The average volatility of ESG funds was 15.46% annually over the past 20 years, versus 15.04% for the S&P 500, according to our analysis. This greater overall volatility could be due to the greater small-cap risk the average ESG fund takes on—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, single-stock risk is another issue to watch out for as an ESG investor. For one in 10 of the ESG funds that we studied, the largest holding in the fund carried a weight of 10% or more. There is considerable risk in focusing that much weight on one holding in a fund.

Investors should be cognizant of these risks before picking an ESG fund. Failing to look under the hood of an ESG investment could result in unwelcome surprises.

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