How sustainable investing really did in this bear market

This is a special story for Callaway Climate Insights subscribers. Watch for our weekly newsletter on Thursday, April 9. -- David Callaway.

Mark Hulbert writes that it’s incumbent on all of us to be honest about what is realistically attainable when investing sustainably. Sometimes virtue has to be its own reward.

CHAPEL HILL, N.C. (Callaway Climate Insight) — My BS detector was triggered in late March when, with the S&P 500 down more than 30% over the trailing month, cheerleaders for climate-change funds began bragging about how those funds were beating the market.

To be sure, many of these funds (though by no means all) were indeed losing less than the overall market. My gripe was with the notion that their market-beating returns since the February high were due to being invested in stocks ranked high on various environmental sustainability scales.

The primary sources of their returns actually were other factors that had nothing to do with sustainability — factors that just as often will work against them.

Before I discuss why, let me digress and stress that I am not against targeting one’s investments to promote responsible climate policies. But I do believe that investing for climate change requires every bit as much rigor as employed by other Wall Street analysts. And, so far, many of the arguments in favor of sustainable investing have left much to be desired — especially the argument repeated almost mantra-like that doing good reliably leads to doing well.

This lack of rigor actually endangers the cause. What if an investor decides to invest in a sustainability fund because of its alleged downside protection during bear markets? That investor almost surely will become disillusioned at some point down the road, thereby tarnishing the cause.

That’s exactly the situation with climate change funds during the recent bear market. Because such funds either are underweight oil company stocks, or have no exposure to them at all, they benefited greatly when crude oil’s price plunged. Oil was trading above $53 a barrel on the day the stock market hit its bull-market high on Feb. 19, versus $20 at the end of March — a drop of more than 60%.

But what will happen when oil’s price shoots back up? If these funds’ cheerleaders try to take credit for beating the market when oil’s price is plunging, don’t they have to take responsibility when their funds lag in the wake of a skyrocketing oil price?

Only if you think that oil’s price will consistently and steadily decline would you want to use oil’s price as a reason to invest in climate change funds. One might hope that alternative energy sources will become so widely used that oil’s price continues to decline from current levels, already the lowest in inflation-adjusted terms since at least the 1970s. But I know of no analyst who is predicting such a drop over the time horizon that realistically can be expected to affect stock prices.

It’s incumbent on all of us to be honest with ourselves and our clients about what is realistically attainable when investing sustainably.

More than just the bear market

To be sure, this discussion has focused on just the bear market of the past six weeks. But the same lesson applies when we focus on performance over much longer periods: Much of the outperformance attributed to ESG funds generally turns out to have been caused by other factors having nothing to do with ESG.

Take, for example, ESG funds’ tendency to invest in large-cap stocks. That has served them well over the past decade, as small-cap stocks have significantly lagged the overall market. Over the past 10 years on a total return basis, the large-cap dominated S&P 500 has doubled the annualized return of the small-cap Russell 2000 index (17.2% versus 8.5%). If the small-caps reassert the historical dominance they previously had (dating back to the 1920s, in fact) then ESG funds will be facing some very stiff headwinds.

The same needs to be said about the typical ESG fund’s tilt toward growth over value. That bias has served the industry very well over the past decade, since growth has trounced value: The S&P 500 Growth ETF (IVW), for example, has doubled the annualized return of the S&P 500 value ETF (IVE) — 22.7% versus 11.7%. But if and when value starts beating growth — which, as in the case of small caps over large caps, is something it has done all the way back to the 1920s — then ESG funds on the whole will struggle.

In almost all cases, in fact, there is nothing left to ESG funds’ much-storied outperformance after we account for their exposures to well-known stock-picking factors such as small-versus-big and growth-versus-value.

That at least is what I found upon analyzing the top-performing sustainable mutual funds that were highlighted in a Barron’s article in January, headlined “Mutual Funds That Rank High on Sustainability Are Outperforming the Market.” (Specifically: Among U.S. equity funds that Barron’s reported to have a Sustainalytics “fund sustainability rating” of “High,” I selected the 10  with the highest 2019 returns that also had at least 10 years of performance that I could feed into my econometric tests.)

For 9 of these 10 funds, it turns out, the fund’s performance was indistinguishable from a benchmark constructed out of the various well-known factors. The one that still beat the market by a statistically significant margin was the Akre Focus Fund (AKRIX). Interestingly, however, this fund is not advertised as focusing on ESG or environmental sustainability — neither of these phrases is even mentioned on its website. And so even this fund helps to make my general point that it is hard to credit sustainable investing for any outperformance.

No free lunch

Once again I arrive at the same conclusion I did two weeks ago: It’s asking too much for a fund to be both highly rated in sustainability rankings and to outperform the market. This doesn’t have to be disappointing, as I also wrote then. It would be only if you thought you’d get paid for doing the right thing.

Am I being too harsh?

For a reality check, I spoke with Robert Stambaugh, a finance professor at the Wharton School at the University of Pennsylvania. He told me earlier this week that far too many in the ESG arena insist that they can have it both ways, in effect to get a free lunch — including many very smart people who should know better.

Sometimes virtue has to be its own reward.

(About the author: Mark Hulbert is an author and financial markets columnist. He is the founder of the Hulbert Financial Digest and his Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at