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Investors eager to align their portfolios with sustainability goals may be in for a surprise.

Researchers studying active U.S. stock mutual funds that claim to embrace environmental, social and governance principles found significant disparities in how these funds operate, revealing a tangled web of strategies that could leave investors questioning whether their values are truly reflected in their investments.

Simona Abis

“ESG labels often mean 100 different things,” said Simona Abis, assistant professor of finance at the Leeds School of Business. “Since we don’t agree on what they all mean, misunderstandings can arise, even when funds are not trying to mislead investors.”

The researchers, including Abis, Andrea Buffa, also an assistant professor of finance at Leeds, and Meha Sadasivam, a PhD candidate at Columbia University, aim to classify ESG funds more accurately by analyzing the investment strategies stated in mutual fund prospectuses.

From the vast pool of mutual funds that invest primarily in U.S. stocks and are actively managed—meaning a fund manager or team picks stocks and makes investment strategy decisions—the researchers identified funds with ESG-related strategies using a dictionary of ESG terminology. They then read each prospectus, a document that provides details about a potential investment, manually. In a  describing the study, the researchers categorized the funds into three types based on what they found:

1. Exclusionary. These funds exclude certain stocks that do not align with their ethical or values-based criteria. Through screening processes, they may eliminate companies with poor labor practices, for example, or those involved in fossil fuels, tobacco and firearms.
2. Impact. Funds in this category consider ESG factors, evaluating company stocks not just for their potential returns but for their impact on society and the environment. For example, they might prioritize companies that have strong sustainability practices or positive community engagement. These funds consider ESG factors above and beyond fund returns.
3. Opportunistic. While these funds also consider ESG factors, they do so only to improve their assessment of a company’s risk factors and/or its return potential. As a result, these funds may invest in companies with lower ESG ratings if they believe they will deliver higher returns.

The researchers found that only 20% of funds using ESG terminology genuinely qualify as impact funds that prioritize non-financial ESG goals, while the majority fall into the other categories.

The ambiguity in terminology used by so-called ESG funds could potentially mislead investors who believe they are supporting funds with a mandate to select holdings aligned with ESG principles, Abis said.

“The challenge lies not just in how funds are labeled, but in the very meanings we attach to those labels,” she added. “Without clear definitions, a fund claiming to focus on ESG might be interpreted in countless ways, leading investors to believe they are supporting impact-oriented initiatives when they might not be.”

ESG investing has experienced a surge in popularity over the past decade, significantly increasing the assets managed by these funds. ESG funds—meaning any funds mentioning ESG terminology in their prospectuses—represented about 4% of the total number of active equity mutual funds in 2015, managing less than 2% of the capital invested in this industry, according to the paper. After only seven years, ESG funds grew by a factor of 5, representing 22% of active equity mutual funds and managing almost 20% of the invested capital.

However, the portion of capital managed by impact funds—those preferring companies with a better societal and/or environmental impact—has dwindled from 40% of the assets managed by funds mentioning ESG terminology in their prospectuses in 2015 to just 6% in 2022, according to the researchers.

Opportunistic strategies

The majority of new ESG funds are now classified as opportunistic, indicating a more flexible approach, or as “mention-only” funds, which often begin as traditional non-ESG funds and later incorporate ESG considerations into their investment processes.

“This contrast highlights a key challenge: When we hear about a surge in ESG investment, we might mistakenly believe that it’s all about saving the planet. In reality, many funds are simply integrating ESG factors for risk management rather than pursuing a dedicated impact agenda," Abis said.

In recent years, the U.S. Securities and Exchange Commission has been developing regulations aimed at increasing transparency regarding ESG claims made by investment funds. These efforts include clearly defining “ESG fund" and ensuring that funds accurately communicate their investment strategies related to environmental, social and governance factors.

Despite this progress toward greater clarity and standardization, Abis said increased scrutiny around how ESG investing is defined and delivered is still necessary. “Even with clearer regulations, if funds do not adopt standardized practices for measuring ESG impact, accountability will remain a significant issue,” she said.

She added that responsibility also falls on investors, who “often overlook fund prospectuses, which contain crucial information about how a fund approaches ESG.” By taking the time to understand a fund’s narrative and look beyond superficial labels, she said, investors can empower themselves to make more informed decisions.