Responsible investing can deliver competitive performance

Interest in responsible investing continues to expand, but questions persist about whether pursuing environmental, social and governance goals requires sacrificing performance. Recent research by TIAA on the performance of responsible investing indexes, however, found no systematic performance penalty over the long term. Moreover, incorporating ESG criteria in security selection did not appear to increase risk.

To evaluate responsible investing's performance impact, we selected five widely known U.S. equity ESG-based indexes with track records of at least 10 years: Calvert U.S. Large Cap Core Responsible, Dow Jones Sustainability U.S., FTSE4Good US, MSCI KLD 400 Social and MSCI USA IMI ESG. We compared returns for these indexes with two widely recognized U.S. equity indexes, the Russell 3000 and Standard & Poor's 500. We evaluated indexes to avoid the difficulty in making apples-to-apples comparisons of investments with differing management approaches, investment characteristics, and fees.

Long-term returns for the responsible investing indexes were similar to one other and to the broad market. Ten-year average annual performance for the five U.S. responsible investing indexes ranged from 6.47% to 7.73% vs. 7.42% for the S&P 500 and 7.4% for the Russell 3000. The gap between best and worst responsible investing index average annual performance spanned 126 basis points. More importantly, statistical analysis showed no significant difference in returns when comparing the responsible investing indexes with relevant broad market benchmarks. Return variations appeared to be random and not systematic.

Key volatility measures of the responsible investing indexes were also similar to the S&P 500 and Russell 3000 indexes, and clustered fairly closely together. Average annualized standard deviations for the responsible investing indexes ranged from 16.02% to 17.41% over the past 10 years compared to 16.79% for the S&P 500 and 17.31% for the Russell 3000.

The spread between standard deviations for responsible investing indexes and benchmarks averaged only 25 basis points for the 10-year period. How is the 25 basis points calculated?

The maximum spread between responsible investing indexes and the broad market indexes averaged only 1.78 percentage points for the 10-year period. Meanwhile, risk-adjusted returns also showed little variation from broad market indexes. Sharpe ratios, which measure risk-adjusted performance, tracked fairly closely, with responsible investing index averages comparable to the underlying market or lagging only slightly. For the 10-year period, responsible investing index average annual Sharpe ratios ranged between 0.75 and 0.85, compared with 0.83 for S&P 500 and 0.81 for the Russell 3000. With standard deviations of returns and Sharpe ratios comparable between responsible investing indexes and market benchmarks, incorporating ESG criteria in investment decisions did not mean taking on additional risk relative to broad market benchmarks.

As expected, all the responsible investing indexes showed tracking error compared to the market indexes as a result of limiting the number of eligible securities. Using ESG criteria in stock selection introduces portfolio biases and causes performance to deviate from the benchmark. Not only did the responsible investing index results show tracking error, there were statistically significant differences across the various indexes — suggesting some responsible investing indexes more closely matched the broad market than others.

Rates were measured from the inception for each ESG index, ranging from 1994 to 2003, and calculated through July 1, 2016, with the MSCI USA IMI ESG index showing the lowest tracking error at 1.75%, and the DJSI U.S. the highest at 3.4%.

Specifically, we compared the MSCI USA IMI ESG index and Calvert U.S. Large Cap Core Responsible index with the Russell 3000 because these two indexes include smaller-capitalization stocks. Average tracking error for the MSCI USA IMI ESG index was meaningfully lower than the 2.67% for the Calvert U.S. Large Cap Core Responsible index.

The remaining three responsible investing indexes were compared with the S&P 500 given their primarily large-cap focus. MSCI KLD 400 Social had a 2.57% tracking error, lower than the 2.86% for the FTSE4Good US and the DJSI U.S. divergence — all by statistically significant differences.

Tracking error does not introduce absolute risk, but is a source of relative risk vs. a benchmark. Institutional money managers, for example, might be constrained by client mandates to limit tracking error within specific ranges and against specific benchmarks.

What drives tracking error?

Variations in tracking error are byproducts of the responsible investing process itself. The five responsible investing indexes use explicit ESG criteria to select a smaller subset of stocks — ranging from 23% to 80% of the number of stocks in the broad-market benchmark — resulting in portfolio characteristics that differ from the market. As of Dec. 31, for example, the MSCI USA IMI ESG index held 1,162 stocks, or 39% of the number in the Russell 3000.

Decisions about how stocks are rated, selected and managed differentiate responsible investing indexes from each other and the broad market. Company assessments may vary depending on the ESG approach, the range of factors considered, and relative emphasis on the “E,” “S,” or “G” components. Differences in index characteristics include sector/industry weighting, market capitalization and number of holdings.

While we analyzed index performance and not actual investment results, our research suggests that responsible investing has the potential to achieve performance comparable to the broad market over the long term without additional risk. Using ESG criteria in index construction did not require sacrificing performance, despite limiting the number of eligible securities by up to 77%. Reducing the universe of eligible stocks, however, did produce tracking error that varied depending on how the index was constructed. As a result, investors should carefully consider how a responsible investing index or portfolio is constructed, the ESG evaluation process and the underlying market benchmark.

Lei Liao is San Francisco-based managing director and equity index portfolio manager at TIAA Global Asset Management.