There is clearly a strong demand by investors for portfolios that reflect their ethical principles. Bloomberg Intelligence estimates that by 2025, somewhere in excess of $50 trillion (more than a third of total funds under management) will be invested with an ESG mandate.
But what does the growth of sustainable investing mean for stock returns? Will ESG portfolios outperform mainstream portfolios, or vice versa? That’s one of the questions addressed in an upcoming book written by TEBI contributor LARRY SWEDROE in conjunction with Sam Adams. It’s called Your Essential Guide to Sustainable Investing: How to live your values and achieve your financial goals with ESG, SRI, and impact investing and includes a foreword by Burton Malkiel.
Although it’s available for pre-order now, the book isn’t due to be published until April 2022. But here’s a sneak preview of what Swedroe and Adams have to say about the impact of ESG on stock returns.
With sustainable investing continuing to gain in popularity, economic theory suggests that if a large enough proportion of investors choose to favor companies with high sustainability ratings and avoid those with low sustainability ratings (“sin” businesses), the favoured companies’ share prices will be elevated and the sin stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium on the screened assets.
The result is that the favoured (“green”) companies will have a lower cost of capital because they will trade at a higher price-to-earnings (P/E) ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). And the sin (“brown”) companies will have a higher cost of capital because they will trade at a lower P/E ratio. The flip side of a company’s higher cost of capital is a higher expected return to the providers of that capital. The hypothesis is that the higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept lower returns as the “cost” of expressing their values. The result is a preference-based, or behavioural, explanation for a brown premium.
There is also a risk-based hypothesis for the brown premium. It is logical to hypothesise that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. The stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium. However, while the brown portfolio should be expected to have higher returns, the green portfolio will have less risk. Thus, risk-adjusted returns could be similar.
Both the behavioural- and risk-based explanations play a role in creating the brown premium. However, this is only one of two channels through which ESG ratings affect stock returns because investor preferences lead to different short- and long-term impacts on stock returns and prices.
A second channel
If there are unexpected cash flows into firms with high sustainable investing scores, earning them rising portfolio weights, those cash flows lead to short-term capital gains for their stocks — realised returns rise temporarily. However, the long-term effect is that 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. In other words, there is an ambiguous relationship between ESG risks and returns in the short term.
The literature also has found that the brown premium is well explained by exposure to the factors in the newer asset pricing models (beta, size, value, momentum, investment and profitability). Thus, sustainable investors can “have their cake and eat it too” by tilting their portfolios to these factors.
Investor takeaways
The literature provides investors with several important takeaways. First, sustainable investment strategies that do not take into account factor exposures should expect lower returns. However, sustainable strategies also reduce risk. Thus, there may not be a sacrifice in risk-adjusted returns.
Second, in the short-term, the increased demand from sustainable investors might be more than sufficient to offset the ex-ante lower expected return as valuations of green stocks relative to brown stocks increase. The result would be that even though brown stocks have higher ex-ante returns than green stocks, green stocks could provide higher ex-post returns caused by their rising portfolio weights.
With that in mind, it seems highly likely that we are in the early stages of the transition to a new equilibrium. In their 2018 research report, Big Data Shakes Up ESG Investing, Deutsche Bank estimated that the share of sustainable invested assets would increase from about 50 percent in 2020 to about 95 percent in 2035. That’s good news for today’s sustainable investors.
Important Disclosure: The information contained in this article is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained in this article is based upon third party information available at the time which may become outdated or otherwise superseded at any time 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. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, confirmed the accuracy, or determined the adequacy of this article. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®, Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-173
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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