Do ESG fund managers have ESG skill?

We know that active fund managers can only beat a benchmark if they have skill in selecting stocks and/or timing the market. But we also know that skill is a rare commodity and the majority of fund managers do not have skill. But what about ESG funds and their skill in picking stocks that improve their ESG credentials over time?

A team from the University of Virginia decided to investigate if there is such a thing as ESG skill and if it translates into better performance for ESG funds. To do this, they took inspiration from the conventional measure of skill, namely the ability to buy stocks when the price is low and sell them when the price is high. Similarly, they defined ESG skill as the ability of fund managers to buy stocks before their ESG ratings are upgraded (i.e. when the ESG performance is low) and sell them when the ESG performance is high.

Using three different ESG ratings methodologies, the study found that close to 50% of ESG fund managers have some form of ESG skill in the sense that they are on average able to buy stocks before their ESG ratings are being upgraded. But that skill is tiny, and the picture becomes much more selective if one is looking for statistically significant levels of skill. If one wants to have a 95% probability that the manager has ESG skill only about 5-10% of managers qualify. And if one wants to be 95% sure that managers have skill across all three tested ESG ratings systems, far less than 5% of fund managers show skill. Lots of numbers but in essence, these numbers say that we cannot rule out the possibility that no fund manager has any ESG skill.

But assume you find a manager that has true skill in identifying companies that will improve their ESG credentials. Does that lead to better performance for the fund? Well, not over investment horizons of 12 months or less. However, there is some indication that over a longer investment horizon of four years, ESG skill translates into higher alpha, but the size of that alpha is small (a couple of basis points).

No surprise here since I always stress that ESG investing is not a way to increase returns but to reduce risks.

But where there is a significant effect of having ESG skill for the fund manager is when it comes to fund flows. Flows in and out of conventional funds do not change when a manager has ESG skill or not but flows to ESG funds and in particular funds to ESG funds marketed to institutional investors change in reaction to the ESG skill of a fund manager. A one standard deviation increase in ESG skill of the fund manager on average leads to additional fund inflows of 0.71% of assets under management per quarter (or roughly 2.8% of assets under management in additional flows per year). For ESG funds marketed to institutional investors the fund flows are even higher at 0.87% per quarter or 3.5% of assets under management per year.