Fund managers and investors are becoming increasingly mindful of carbon risk and how climate change will impact the value of portfolios and individual assets. Totally separate to the ethical issues surrounding so-called sustainable investing, there is an ongoing debate as to whether funds with higher carbon risk exposure will underperform or outperform the broader market in the long run. It’s a complex issue, but, as LARRY SWEDROE explains, new research by the University of Massachusetts provides us with some helpful pointers.
Given increasing concerns about the risks of climate change, investors should understand how climate change affects institutional investors such as the mutual fund industry. Not only are funds exposed to the risks of climate change, but through their actions, including engagement, they can incentivise companies to act in more sustainable ways.
Huan Kuang and Bing Liang contribute to the sustainable investing literature with their August 2021 study, Carbon Risk Exposure in the Mutual Fund Industry. Using Sustainalytics’ Carbon Risk Ratings, they constructed a carbon risk measure for mutual funds based on stock holdings data and explored how carbon risk affects mutual funds’ performance, risk and flows.
The authors noted: “The Carbon Risk Ratings span more than 4,000 public companies, encompassing 147 subindustries globally, and capture a variety of carbon signals in a single quantitative assessment. Compared to carbon emissions data (which is a static measure of a firm’s current state of carbon intensity), this measure is forward looking and can capture a firm’s ability to transition to a low-carbon economy more dynamically.” They also noted that the Carbon Risk Ratings are used “by Morningstar to create the Morningstar Portfolio Carbon Risk Score, a measure that helps investors evaluate a portfolio’s exposure to carbon risk.”
Kuang and Liang also constructed an asset-weighted composite ESG (environmental, social and governance) score for each fund. Hypothesising that institutional investors have a better understanding of climate change risk, are under more pressure from outside investors and have better access to firm-level carbon risk data, they split their data sample into institutional investor funds and retail investor funds.
To distinguish their carbon risk scores from the traditional ESG measure, they used MSCI ESG KLD STATS to access firm-level ESG ratings. Their final sample comprised 1,695 U.S. equity domestic active funds and covered the period 2012-19.
Following is a summary of their findings:
- Funds with higher carbon risk exposure had statistically significant (at the 1 percent confidence level) lower performance and higher unexplained risk in four- (beta, size, value and momentum) and five-factor (beta, size, value, investment and profitability) models.
- Funds with low carbon risk had statistically significant (at the 1 percent confidence level) lower total volatility and attracted more fund flows.
- Institutional investors take carbon risk more seriously than do retail investors.
- For funds with higher carbon risk exposure, the flow/ performance relation is more sensitive.
- The previous period’s fund performance is highly correlated with the next period’s fund flows, suggesting that investors are chasing well-performing mutual funds.
- When there is more news coverage on climate change, carbon risk exposure affects fund flows more negatively — mutual fund investors follow climate change news and pay close attention to funds’ carbon risk exposure.
- Carbon risk exposure was weakly correlated with the ESG score — their carbon risk score is a unique measure of risk, adding value to existing ESG measures.
- These findings did not apply to retail funds — retail investors were not as focused on ESG issues as were institutional investors.
Their findings led Kuang and Liang to conclude: “We find that mutual funds with higher carbon risk generate lower raw and risk-adjusted performance. Higher carbon risk also leads to more unexplained risk. We also show that institutional investors respond to carbon risk promptly.”
It’s important to keep in mind that investor preferences can lead to very different short- and long-term impacts on asset prices and returns. With the increasing trend to sustainable investing, firms with high sustainable investing scores are earning rising portfolio weights, leading to short-term capital gains for their stocks — realised returns rise temporarily. However, the long-term effect is that those higher valuations reduce expected long-term returns. The result can be an increase in “green” asset returns even though “brown” assets earn higher expected returns either due to investors demanding a risk premium or investors simply preferring to not own their stocks. In other words, there can be an ambiguous relationship between carbon risk and returns in the short term.
Over time, as the markets develop a better understanding of carbon risk and the unexpected component falls relative to the expected component, we should expect a positive relationship between returns and carbon risk. Without this understanding, investors can misinterpret findings that appear to show a lack of a carbon risk premium.
However, there is no conflicting evidence when considering risk, as the research, including studies such as Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance, has found that companies with strong ESG characteristics typically have above-average risk control and compliance standards across the company and within their supply chain management. In addition, because of better risk-control standards, high ESG-rated companies suffer less frequently from severe incidents such as fraud, embezzlement, corruption or litigation cases that can seriously impact the value of the company and therefore the company’s stock price. And less frequent risk incidents ultimately lead to less stock-specific downside or tail risk in the company’s stock price.
Important Disclosure: The information presented here is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured author are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-146
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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