The standard argument holds that incorporation of ESG considerations into asset management brings two-fold benefits. First, it helps mitigate risks by avoiding companies that do not pay attention to environmental regulations, social impacts of their business, or principles of good corporate governance. These companies are more exposed to negative press, customers’ backlash, and regulatory or legal actions.
Second, the awareness of social issues, following good environmental practices and adherence to good corporate governance are testimonies to overall good management of the company, which in turn bodes well for its long-term prosperity.
Some mutual funds have incorporated ESG considerations and Morningstar aims to quantify them with the Portfolio ESG Score. The score is intended to reflect how well a firm is addressing ESG issues based on a series of indicators measuring preparedness, disclosure and performance.
In the universe of 1376 mutual funds available for sale in Hong Kong with a three-year track record, 702 have an assigned portfolio ESG score.
FSA has performed a simple statistical analysis with a goal to find out if higher ESG scores correlate with better performance of funds. We chose six major categories: European equities, US equities, China/Greater China equities, Asia-Pacific ex-Japan equities, global equities and global emerging market equities.
On average, European equity funds have the highest ESG scores, while China/Greater China equity funds − the lowest. China/Greater China equity funds had the biggest dispersion of three-year excess returns (the returns above the category benchmark), compared to the other categories.
In a surprising result, the fund ESG scores correlate negatively with their three-year excess return. In other words, the higher the ESG score of a fund, the poorer, on average, its performance vs the benchmark.
(Positive correlation means that higher ESG scores imply higher excess returns, negative means that higher ESG scores imply lower excess returns. The closer the number to 1 or to -1, the stronger the effect).
Correlation of funds’ ESG scores and excess returns
| Fund Category | Correlation |
| Europe equity | -0.31 |
| US equity | -0.29 |
| Global equity | -0.23 |
| Emerging markets equity | -0.21 |
| Asia-Pacific ex-Japan equity | 0.03 |
| China/Greater China equity | 0.13 |
Data: Morningstar. 3-year annualised excess returns in US dollars, as of 28 February.
Excess returns are against the funds’ Morningstar category benchmark.
This held true for European equity, US equity, global equity and global emerging market equity funds. The two notable exceptions were China & Greater China equity funds and Asia-Pacific ex-Japan funds, which showed a positive correlation, although in both cases it was quite weak.
In most categories, we found that the funds with the highest ESG scores underperformed their benchmarks, while the ESG scores of the best performers were, at best, mediocre.
3-year excess returns vs ESG score
Data: Morningstar. 3-year annualised excess returns in US dollars, as of 28 February.
Excess returns are against the funds’ Morningstar category benchmark.
It appears that, despite the arguments to the contrary, ESG investing still quite frequently implies long-term underperformance.
However, the incorporation of ESG considerations appears to have a tangible − if weak − benefit in the management of China/Greater China funds.
