If you’d like to align your retirement investments with your values regarding environmental and social goals, then an important question to ask yourself is whether focusing on sustainable investments will create a drag or a boost on your investment returns.
The short answer is, “It depends on a few things.” Specifically, it’s critical to compare any sustainable investment you’re considering to conventional investments with similar investment goals, since there can be several ways to structure a sustainable investment. Also, when comparing different investments, you’ll want to analyze returns during different time periods.
Fortunately, the respected financial research firm Morningstar has a robust section on their website that analyzes various types of sustainable investments and their returns. Morningstar’s analyses use the ESG framework that has emerged over the last few years to evaluate investments with respect to environmental, social, and government goals (hence the acronym ESG).
Comparing returns during 2022
During 2022—an unusual year for stock and bond markets—Morningstar’s analyses show that some sustainable investments outperformed comparable investments without a sustainable focus, while other sustainable funds underperformed. For example, Morningstar’s U.S. Sustainability Index tracks large and mid-cap companies with low ESG-risk ratings; these companies represent about half of the total number of large and mid-cap companies. During 2022, Morningstar’s U.S. Sustainability index lost 18.9%, compared to a loss of 19.5% for the entire list of companies. The S&P 500 overall lost 19.4%.
Digging down on some of the reasons for the varied performance during 2022 illustrates a few of the complexities and nuances to take into account when comparing the returns of sustainable investments to conventional investments. During 2022, oil companies outperformed the overall market, in large part because of the surge of the price of oil due to the war in Ukraine. Sustainable funds that shunned oil companies missed out on that good performance, compared to conventional large-cap funds that included oil companies.
On the other hand, tech stocks, such as Amazon and Tesla, lagged other investments during 2022. If a sustainable fund loaded up on these stocks because they were considered environmentally friendly, then the underperformance on those stocks would also be a drag on the investment returns.
Comparing returns in 2021 and before
Morningstar’s analyses for 2021 and for the previous six-year period show that ESG funds tended to outperform, on average, funds that don’t use an ESG approach for evaluating investments. One reason for this favorable performance is that large tech stocks are often considered to be positive with respect to ESG goals, and the returns on those firms generally beat the market during the years leading up to and including 2021. Similarly, ESG funds tended to shun oil companies, which underperformed the market during these periods.
Results are mixed
A broader internet search on the impact of ESG investing on investment returns produces studies with varied results. For example, general support for the conclusion that ESG principles can help outperform the market is provided by studies published by The Forum for Sustainable and Responsible Investment and ESG The Report.
Note, however, that these organizations are generally supportive of ESG investing. As a result, skeptics might consider them to be biased in favor of ESG investing.
On the other hand, a recent article in the Harvard Business Review is more critical of ESG investing, suggesting that it might not result in outperforming the market.
These varied results bring to mind the behavioral economics phenomenon called “confirmation bias,” when people tend to look for evidence that supports their existing beliefs.
The reality is, with the recent proliferation of ESG funds, there hasn’t been enough time to thoroughly evaluate and compare their performance to non-ESG funds over long periods of time that are appropriate for retirement investing. As a result, retirees who need convincing evidence that the return on their investments won’t suffer might want to hold off on committing to ESG investing. Other retirees who are more willing to tolerate potentially reduced returns may see this evidence as an acceptable price to pay to align with their social and environmental goals; if their returns happen to outperform the market or at least pace the market, it’s just icing on the cake.
As you consider your investing strategies, you’ll need to make investment decisions with a mix of analysis, faith, and a reflection on how important it is to you to invest your retirement savings in alignment with your environmental and social goals.