By some measures, Americans are investing more of their money with their conscience, and perhaps their politics, in mind, than ever before.

According to the US SIF Foundation, a nonprofit that advocates for “sustainable, responsible, and impact” investing, $12 trillion—or 25 percent of all professionally managed investments—were held in funds that met criteria for environmental, social, and governance compliance in 2018.

That represents a nearly 40 percent increase from just two years prior, and a 400 percent increase since 2010, when ESG-compliant investment funds held $3.07 trillion.

Growth in ESG funds has outpaced the growth of conventionally managed assets. Along the way, proponents of ESG strategies have touted the funds for not only their moral superiority, but also for their ability to outperform traditional investment strategies.

The latter claim is questionable, according to Wayne Winegarden, an economist and senior fellow at the Pacific Research Institute, a think tank that advocates for free-market policies.

“It's perfectly fine for an individual to choose to invest their money based on social and environmental issues,” said Winegarden, who is also a principal of Capitol Economic Advisors. “But if you are selling ESG funds on their better return track record, there's some deception there.”

In a new paper, Winegarden looks at 30 ESG funds that have either existed for more than 10 years or have outperformed the S&P 500 over the short term.

Of the 18 funds that have a 10-plus year record, only one beat an S&P 500 benchmark investment over a five-year time period, and only two ESG funds beat the S&P benchmark over a 10-year investment period.

A $10,000 investment, equally divided among the 18 ESG funds with an established track record, would have generated 44 percent less over 10 years than the same money invested in an S&P 500 index fund.

Eye of the beholder

As more money managers have rolled out ESG-defined mutual funds, a precise definition of environmental, social and governance investing has yet to emerge.

“The definition is in the eye of the beholder,” said Winegarden. “We try to pretend like there is some real, defining criteria, but there isn't. And that's problematic.”

Winegarden split the 30 funds into three groups. The best performing funds were broad-based index funds with minor exclusions from investments in tobacco companies and gun manufacturers.

A second ESG category, dubbed “waste and clean tech” by Winegarden, included 11 funds that invest in alternative energy and clean waste companies in pursuit of explicit environmental goals.

None in that group outperformed the S&P 500 index, which posted 12.4 percent average annual returns over 10 years. The worst performer in the group—the Invesco Solar ETF—which tracks an index of solar companies, lost an average of 11 percent annually. The best performer, the Fidelity Select Envir and Alt Energy Portfolio, returned an average of 7.9 percent.

A third category, called “social goals,” actively invests in companies with explicit social criteria, such as gender diversity in the C-suite or companies guided by the United Nations Sustainable Development Goals.

Only three of the eight funds have a 10-year track record. Two of those beat the S&P 500 Index over 10 years: the Eventide Gilead Class N fund, which invests in companies with ethical governance, averaged 14.3 percent; the Parnassus Endeavor Fund, which invests in companies with good workplaces for their employees and avoids fossil fuel companies, returned an average of 12.7 percent.

Two big no-nos

The average expense ratio for the 30 ESG funds was 69 basis points, compared to 9 basis points for the SPY S&P 500 Index Fund.

ESG funds also carry greater diversification risk. On average, the top 10 holdings in the funds account for 37 percent of invested assets, compared to 21 percent in the S&P Index Fund.

“When you look at the cost and holdings of the funds, they are more expensive and less diversified,” said Winegarden. “Those are two big no-nos. It's difficult to believe narrowing your investment options is growth producing.”

Despite higher costs and what in most cases are slack returns, more investors are flocking to ESG funds. The question is why.

“The principal conforms to the world the way we want it to be,” said Winegarden. “People want to hear the message that they can save the world and make a lot of money.”

Ten of the 30 ESG funds beat the S&P Index over one year; three beat it over five years.

Short-term performance can make for great hype, but ultimately proves little, said Winegarden.

“A lot of these funds are new, and haven't experienced a bear market,” he added. “Until they get through a full cycle, we really won't have the full answer to how well they perform.”

Individual investors are of course free to prioritize non-financial goals over investment returns—something Winegarden does not begrudge.

He does have concerns when institutional investors, such as public pension funds, prioritize ESG investing over returns.

“When you cross that line into a public pension, you raise all kinds of issues,” he said. “People want clean energy to be cheaper, but we are not even sure much of the technology is viable.”

He noted the experience of Tesla, which is a top 10 holding on four of the clean energy ESG funds Winegarden analyzed.

“Tesla looks to be in trouble. If it does poorly, those funds will suffer for a long time. And now we have all this money flowing into what could be the Delorian of the 21st Century,” he said.

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