The cost of insuring against underperformance of ESG screened index funds

Abstract

ABSTRACT

In recent years, investors have shown significant interest in responsible investment products, including sustainable and ESG screened index funds. A natural concern for prospective investors in such funds is that a sustainable fund might underperform its classical unscreened counterpart. This paper argues that this underperformance risk can be analyzed by way of an option to exchange one asset for another, and we derive a simple formula that quantifies the fair annual insurance premium for covering this risk. Only a single parameter is needed to apply the formula. This parameter – a relative index volatility – is readily estimated from market data. Our empirical work utilizes data from BlackRock's ETF (iShares) universe to estimate the cost of insuring against underperformance risk of some common ESG screened funds. We find that the fair cost of underperformance insurance typically corresponds to sacrificing in advance between 0.5% and 3.0% of the annual return.