• The Ethical Investor

Do sustainable investments underperform traditional investment?

There is a common assumption that investing ethically delivers lower returns than traditional investing.

We’ve taken a look at the numbers behind this to see whether or not this really is true- with some interesting conclusions.

The takeaway- socially responsible investment (SRI) funds generally outperform those without ethical screens. However, the reasons behind this may not solely come down to the ‘sustainable’ factor, but many other biases such as sector bias and greater concentration towards particular countries. The conclusion- know what you are investing into and choose wisely!

Performance – SRI v Traditional

The table below shows returns over the past 5 and 10 years from the main MSCI indices and Vanguard funds. The SRI versions of the indices or funds aim to exclude companies with the worst environmental or social impacts. They do this by grading each company on their environmental, social and governance (ESG) credentials. While there are some questionable companies that remain in the SRI indices, nevertheless a lot of the worst contenders are culled.

In all cases, the SRI versions have outperformed their traditional counterparts- both from a total return and a risk perspective. The SRI versions also have suffered from slightly lower maximum drawdowns over these periods (i.e. the maximum loss from peak to trough that the index has suffered).

Our analysis suggests that this holds true across all geographies- so SRI has done better not just globally and in emerging markets, but in Europe, Asia and other regions as well.

This paints a great picture for ethical investing, however to us three major questions stand out:

  • What about over longer time frames- 10 years may not be long enough to get a full picture.

  • Could outperformance be driven from certain biases that SRI investments have over traditional investment?

  • How about active funds?

What about the longer term picture?

The trouble with this question is that, frankly, there isn’t enough data on long term SRI performance, as dedicated funds and indices have only come into existence in the last few decades.

One of the earliest ethical indices are the FTSE4GOOD series, which started in 2001. These indices have slightly outperformed their traditional counterparts in much the same way that the MSCI indices have done over the past 10 years.

While long term SRI fund performance is lacking, many academic studies have looked into the performance question, with many constructing their own universes and selecting different time periods.

One of the most comprehensive studies (link here)- an Oxford University meta-study of more than 200 academic studies into this topic- found that approximately 80% of them show that stock price performance is positively influenced by good sustainability practice.

One of the most influential studies into this is a Harvard Business School review (link here) conducted in 2012, which found that companies with ‘high sustainability’ outperformed a ‘low sustainability’ portfolio by 4.8% per year. This study focused on 180 US companies over the period 1993- 2009.

Real world and academic literature supports the idea that SRI outperforms traditional investment, however this is only based on data over the last 30 years or so. While the more years of data the better, the good news is that the last 30 years has seen a number of market scenarios to test many theses and situations.

2. Can outperformance just be from sector bias?

Sustainable funds and investments have performed particularly well relative to traditional investments over the last 10 years, in a time when the global stock market- and in particular the technology sector- has performed very well. Looking under the bonnet of these funds is absolutely necessary to determine whether it is sustainable criteria driving investment returns, or some other factors.

One frequently mentioned point is that SRI funds have certain sector biases compared to traditional passive funds. Entire sectors such as tobacco and weapons are not included in almost all of them, while sectors that naturally have fewer environmental or social issues are overrepresented. For example, the Technology industry typically doesn’t have many environmental concerns as they are not as polluting as Oil & Gas, Utilities or Manufacturing companies.

Below shows the difference in sector exposure between the MSCI World and its SRI version.

The biggest differences are an underweight position in the SRI index to the Communications sector (-3.4%) and an overweight to Consumer Staples (+2.4%). There is also an overweight to Technology companies (+1.7%).

Sector bias has generally had a positive effect for the MSCI World SRI relative to the normal index. This is especially true in its overweight position to the Technology sector. However, as can be seen in the table above, the differences in sector weightings are not extreme, with a mix of positive and negative attributions to sector bias.

The case is much more pronounced for the MSCI Emerging Markets index. There are three sectors with a difference in weighting of more than 5% between the SRI and traditional index.

The sector differences are much greater for the MSCI Emerging Markets indices, and the difference in performance on a sector level versus the total index level is also much greater. The 16% greater weighting to the Technology sector in the SRI index against the traditional index has a significantly positive effect, as the Technology sector outperformed the total MSCI Emerging Markets index by more than 8% per year over the past 10 years.

Stock- specific bias

In addition to sector biases, the performance of each individual company in an SRI index has a much greater effect on the performance of the overall fund compared to its traditional parent fund. This is because SRI funds and indices screen out companies that don’t meet the ethical criteria and are therefore more concentrated than their traditional counterparts. For example, the MSCI World SRI index has 390 companies in it, compared to more than 1,600 for the traditional index.

The top five holdings in the MSCI World and Emerging Market SRI indices (and their weightings in their parent indices) and shown below.

It is surprising that the SRI indices are so much more heavily weighted to their largest holdings compared to their parent indices. Investing into an SRI fund is therefore much more a bet on the performance of individual companies than with traditional indices.

The table below we shows the performance of the three largest holdings in both the MSCI World and Emerging Markets indices.

It is clear from this that a large part of the strong outperformance of the SRI passive funds relative to their parent indices can be explained by the larger weightings to particular companies- most notably Microsoft (for the MSCI World) and Taiwan Semiconductor (for the MSCI Emerging Markets). It is important to note that there is of course an element of survivorship bias in strong performance of the larger companies in the indices.

So what does this mean? Effectively, by investing in an SRI index tracker, your investment will deliver broadly similar returns as the market, however it is likely to be different by at least 1- 2% per year. You will have different exposures to certain sectors and companies compared to the market; the larger the difference, the greater the difference in performance. From a purely financial perspective, you must be comfortable having over- or under- weights to various sectors which may outperform or underperform over the years ahead.

A note on risk

SRI indices are more concentrated (there are fewer companies in the fund) than the traditional indices. As a result, the individual performance of companies matters more to the overall movement of the fund- meaning that you would ordinarily expect an SRI fund to be more volatile than the normal index.

However, passive SRI funds have consistently shown to have less volatility, and less overall risk, than the traditional index. This is not what you would expect when you consider SRI passive funds are more concentrated.

Academic studies have suggested that companies with strong SRI characteristics are less risky than those with poor SRI records. The theory is that companies that pay more attention to environmental, social and governance issues will likely have fewer of these problems than companies who don’t pay them enough attention. This certainly seems to be true in practice, with lower volatility and lower maximum drawdowns over all periods.

3. How about active funds?

Our analysis has focused mainly on SRI index funds (and therefore the market as a whole)- and how these perform compared to their traditional counterparts.

However, active funds which target specific ethical, environmental or social issues are growing significantly in popularity. This is at a time when inflows into traditional active funds are generally on the decline, as studies have shown that the average active fund underperforms the broader market.

The two questions to consider are:

  • Do active ethical funds outperform traditional active funds?

  • ​Do active ethical funds outperform passive funds?

There haven’t actually been a great deal of academic studies into either of these topics, so it’s difficult to form a solid conclusion. Looking at the investment performance of ethical active funds, it really depends on what time frame you look at as to whether they, on the whole, outperform traditional active funds and/ or the passive benchmark. For example, various analysis such as here and here come up with varying conclusions.

There is no definitive answer as to whether SRI active funds outperform or underperform- like all other active funds, it entirely comes down to what fund is chosen. Similarly to looking at passive fund investment, it is therefore incredibly important to know what you are investing into when choosing an active fund. The fund manager’s strategy, sector and geographic biases and concentration all have a major part to play in ultimate performance of the fund.

While the average active fund has had bad press based purely on financial terms, there are several advantages that active SRI funds have which make many of them interesting and rewarding investments:

You decide on what strategies you believe in ethically and can direct your capital towards these. You may want a strategy that focuses on gender equality, such as the L&G Future World Gender in Leadership UK Fund, or a strategy that focuses on building renewable power, such as Greencoat Renewables PLC.


An active manager (in theory) has a much greater understanding of their portfolio companies and engages with them frequently, meaning that with their expertise they can find the best companies for the planet and society, and help shape them for better.

The bottom line

  • On average, companies with strong SRI credentials outperform over the long term. Investments into SRI passive funds have returned more- with less risk- than their traditional versions.

  • ​​However, this can largely be attributed to various biases displayed by passive SRI funds, such as sector bias and greater concentration towards particular companies.

  • ​​There is no definitive answer as to whether active SRI funds outperform the benchmark or relative to traditional active funds- it really depends on the timeframe and what funds you look at.

  • ​​There are some benefits in investing into active SRI funds over passive SRI funds, in that you can decide on what strategies you invest in to, and the ethical component is managed more effectively.

  • ​​The main takeaway: It is a must that you know what you are investing into! You need to be aware of, and comfortable with, different exposures to certain sectors or companies which will cause deviation from benchmark performance. This is especially true for active strategies!