Going Active Can Boost Performance of ESG Funds
March 28, 2023
Environmental, social, and governance (ESG) funds that are more actively managed and consider metrics beyond third-party ratings tend to outperform. That’s according to a new research paper from Professors Martijn Cremers and Rafael Zambrana of the University of Notre Dame and Professor Timothy Riley of the University of Arkansas.
The professors developed a metric called Active ESG Share with the goal of measuring whether a fund manager is analyzing a variety of information or simply using a fund’s third-party rating to make ESG investment selections.
Active ESG Share captures “how actively a manager uses ESG information, rather than whether the manager tends to favor stocks with high or low ESG ratings,” say the professors. A higher Active ESG Share indicates “increased use of ESG information by the fund manager when making active portfolio decisions.”
Active ESG Share’s Impact on Performance
The paper shows that funds with a high Active ESG Share often outperform funds that base their investment selections on third-party ratings alone.
The professors also found that funds that carry stocks with significantly different scores from the various providers tend to perform the best, as there is a lack of clarity and standards among the ESG ratings agencies.
In fact, that lack of clarity may create additional opportunity for active managers, as active managers are “most likely to have the opportunity to identify and utilize material information not yet incorporated into prices.”
Often the funds are holding stocks that have low ESG ratings, either because the investor believes the ratings agencies are wrong or believes the company will increase its ESG score, something that would not be possible if funds just relied on ratings.
“ESG information is complex, such that ESG ratings alone cannot capture its material components. Only fund managers specialized in processing such complex information can incorporate it successfully into their investment process,” the paper states.