Beyond the Label, ESG Funds May Miss Their Mark

People are growing more interested in how they can make investment decisions which also align with their views about climate change and sustainability. The market has responded with an increasing number of solutions carrying environmental, social and governance (ESG) type labels.

However, the absence of a universally-accepted definition of ESG investing has led to a wide array of different approaches and outcomes, both in terms of investment methodologies and sustainability profiles.

What we do know is that it is possible for investors to align their sustainability and financial goals within a sound investment framework that targets measurable ESG outcomes while pursuing higher expected returns and diversification. But discretion is required.

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So where do you begin? Part of the issue in judging between different options is the absence of a universally-accepted definition of ESG investing. This has resulted in a broad array of approaches that vary in the components considered, the variables by which those components are measured and the method of incorporation. This presents a potential dilemma for investors as these differences can lead to a wide range of investment outcomes. 

It’s against that background that Dimensional Fund Advisors carried out a study of ESG-focused funds. What we find is significant variation in both fund characteristics and sustainability profiles. 

The results of this study serve as a reminder to advisers and their clients to look beyond ESG branding in evaluating whether the chosen investment approach is consistent with the investor’s goals.


The first sign of a varied ESG investment landscape is the breadth of investment categories among ESG-focused strategies. Chart 1 shows the Morningstar category breakdown for a sample of US equity mutual funds and ETFs categorised as sustainable investments as of 31 October, 2020. 

While the majority of the $131 billion in this sample’s assets under management (AUM) is focused on largecap stocks, the 165 ESG funds are spread across 16 categories – spanning size, style, and sector composition. In contrast to the mutual fund industry at large, the majority of these ESG funds are actively managed; less than 40% by net assets were categorised as index funds. 

While research suggests ESG characteristics do not provide additional information about expected returns, an emphasis on ESG characteristics might impact the performance of these strategies. For example, if the incorporation of ESG considerations leads to a systematic over or underweighting of drivers of expected returns, such as size, relative price, or profitability, the expected returns of ESG strategies may be systematically higher or lower than the expected return of the market.

Viewed in aggregate, ESG-focused US equity funds differ from the broad US market. Characteristics for an asset-weighted sample of ESG funds as of 31 October, 2020, in Chart 2 show a tilt toward higher relative price and smaller market capitalisation than the Russell 3000 index. Interestingly, the number of distinct US stocks included in the aggregate ESG sample totals more than 2,700, approaching the index’s 3,023 holdings. This implies that, depending on whom you ask, more than 90% of stocks in the US market fit the bill for ESG investing.

Aggregate characteristics obscure the range of outcomes across ESG strategies. Chart 2 also shows characteristics for the cross-section of ESG funds at the 25th, 50th, and 75th percentiles of the distribution. Portfolio positioning runs the full spectrum along all three characteristics. In particular, the inter-quartile range of weighted average market cap spans from a market-like $348 billion down to under $25 billion, the latter bordering on mid-cap territory. The observed variation in size, relative price, and profitability implies meaningful differences in expected returns among these funds.

In addition to the individual fund characteristics, the results indicate many ESG funds select only a small subset of companies, leading to a limited investment universe and lower diversification. Chart 2 shows, at the 25th percentile, the number of stocks held in a sustainability fund is just 34.

With so many approaches to ESG investing, one might expect substantial variation when assessing strategies through the lens of any individual ESG measure. This is exactly what we see in the greenhouse gas (GHG) emissions exposure data for our sample of ESG funds. As shown in Chart 3, both the emissions intensity and potential emissions of ESG funds in aggregate are meaningfully lower than those of the broad market. But the range of reduction is considerable. For example, for the 75th percentile of funds, emissions intensity is 11% lower than that of the Russell 3000 index; by comparison, the reduction is 61% at the 25th percentile.

The emissions results are instructive in the context of investor expectations. The latest science unequivocally pinpoints GHG emissions as the primary contributor to climate change, and data on GHG emissions are widely available for public companies. To the extent that investors expect an ESG investment to reflect their concerns over environmental sustainability, the wide gamut in    emissions exposure outcomes may be disappointing.


Dimensional’s findings show that the ESG label is hardly prescriptive when it comes to investing, highlighting the importance of evaluating an investment approach based on one’s goals. Those with concerns over climate change may seek out strategies with reduced exposure to companies and sectors that drive climate change through carbon emissions. That means asking questions of the investment managers to evaluate which ones have delivered on the claim of reducing exposure to emissions versus simply paying lip service.

Investors should also be wary of claims by ESG managers that their sustainability funds will meaningfully impact climate change. There is a distinction between GHG emissions exposure in one’s asset allocation and actual GHG emissions in the real world: just because you’re not holding shares of a company doesn’t mean it stops burning hydrocarbons. 

As a result, while managers may use divestment to avoid companies with high GHG emissions, this does not mean that these types of strategies necessarily have a real-world impact. Investors should make sure that managers claiming to have actual real-world impact can provide objectively measurable reporting that backs up their claims. 

Warwick Schneller is a senior researcher and vice president with Dimensional Fund Advisors.

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