How much is a sustainability label worth?
If you look through the factsheets of index and actively managed funds, you immediately realise that sustainable funds charge higher average fees. In the US, the average index fund with an ESG mandate has an expense ratio of some 10-20bps above traditional index funds. Given that most index funds in the US charge less than 20bps, this premium implies some 50% more revenues for the providers of sustainable index funds.
Expense ratio of index funds by assets under management
Source: Baker et al. (2022)
But the real question is, how much a sustainability label is worth to investors? How much are investors willing to pay to invest in a sustainable version of an otherwise identical conventional fund? Malcolm Baker and his colleagues approached this question using index funds in the US. The problem with most actively managed funds is that it is hard to make apples-to-apples comparisons. The sustainable funds of firm A may be managed by a different team or different fund manager than the conventional funds of the same company. But even if the managers are the same, the investment process applied to a sustainable fund may be significantly different than for the equivalent conventional fund.
This is less of a problem in the index fund world because index funds are strictly rules-based. The only difference between an index fund tracking US large cap stocks and an index fund tracking US large cap stocks with a sustainability overlay are rules to exclude some sectors and to choose best-in-class companies within each sector. Differences between the conventional and the sustainable index fund from the same asset management company tracking the same universe are thus minimal and not due to a fund manager making a judgement call.
Using these similarities, one can try to estimate the additional fees investors are willing to pay for sustainable index funds of an asset manager compared to its conventional index funds. And the answer is, on average, investors are willing to pay an extra 20bps in fees to get a sustainable index fund. However, this premium is rising quickly. In 2019, the estimated premium was 9bps. By 2022 it had tripled to 28bps.
Investors are willing to pay an increasing premium for sustainable funds
Source: Baker et al. (2022)
The reasons why investors are willing to pay this premium for sustainable index funds are unclear. Basically, there are two possibilities. On the one hand, investors may expect sustainable funds to have different returns than conventional funds in the long run. On the other hand (and this to me is the more likely reason), investors get other benefits from sustainable index funds like bragging rights with their friends and family or the ‘warm glow’ of knowing that none of the money is invested in companies that may harm the environment, etc.
Whatever the explanation, though, they allow us to calculate an estimate of how much investors are willing to pay in extra fees to actively managed sustainable funds. In theory, excluding some industries should lower returns for sustainable index funds. In practice, this is not the case as I have explained here and the index funds examined in the study have no return difference from conventional index funds. Yet, if we assume that investors are willing to accept lower returns for sustainable funds, one can calculate the true premium for sustainable funds on a like-for-like return basis. And the estimate for this like-for-like premium is 66bps.
Another approach to estimating the premium investors are willing to pay for actively managed sustainable funds is to look at the overlap between conventional and sustainable index funds. On average, the two types of funds have an overlap in their holdings of some 60-70%. The rest can be considered the ‘active component of the sustainable index fund’. If we look at sustainable index funds this way then investors are effectively paying 62bps more for the sustainable overlay than what they are willing to pay for a conventional index fund.
And if you are confused by the numbers now, I’ll summarise it thus: sustainable index funds can charge a premium of 20bps, while actively managed sustainable funds can probably charge a premium of 60bps or more compared to a similar conventional fund. And that is a large boost to revenues for asset managers which is why it should surprise no one that sustainable funds are mushrooming everywhere.