By LARRY SWEDROE
According to the 2020 Report on U.S. Sustainable and Impact Investing Trends, environmental, social and governance (ESG) investing now accounts for more than one-third of total assets under management in the U.S., or about $17 trillion, a 42% increase since 2018. The increase in cash flows has been accompanied by an equivalent increase in academic research into the effect of sustainable investing on investment performance.
Siri Tronslien Sagbakken and Dan Zhang contribute to the sustainable investment literature with their study European Sin Stocks, published in the November 2021 issue of the Journal of Asset Management, in which they examined the performance of sin stocks. In addition to stocks in alcohol, tobacco, gambling and defense sectors that are traditionally considered sin stocks, they analyzed stocks in carbon-intensive sectors that have newly evolved as sin stocks, such as oil and gas, metals and mining, uranium, and coal.
To investigate their return performance, they ran time-series regressions with factor models and Fama-MacBeth cross-sectional regressions. Their data sample covered European sin stocks and their peers over the period 2006-2020. They chose 2006 as the starting point because the “new sin” is a relatively recent concept: The Principles for Responsible Investment (PRI), the world’s leading proponent of responsible investment, were first launched in April 2006. They also split the sample into the pre- and post-Paris Agreement periods, namely 2006-2015 and 2016-2020, in order to identify potential patterns following the adoption of the Paris Agreement and its impact on the new sin stocks.
To identify the peer stocks for the new sin stocks, they selected stocks in the Thomson Reuters Business Classification (TRBC) industry group “renewable energy”, and included the TRBC industry “forest and wood products” as a comparable to new sin industries. For tobacco peer stocks, they chose stocks in “food processing.” For military and defense peers, they chose stocks in “industrial machinery and equipment,” “heavy machinery and vehicles” and “electrical components and equipment.” For wine and beer production peer stocks, they chose stocks in “non-alcoholic beverages.” For casino and gaming peer stocks, they chose “leisure and recreation” and “hotels, motels and cruise lines.” Following is a summary of their key findings:
- Consistent with findings from prior research (for example here and here), the alphas for traditional sin stocks were statistically significant at 5% for the CAPM (market beta), Fama-French three-factor model (adding size and value) and Carhart four-factor model (adding momentum); and insignificant for the Fama-French five-factor model (adding profitability and investment) — the seemingly positive sin premium was driven by the two new profitability and investment factors, and not by the fact that they are sinful and riskier. This held true for both new sin and traditional sin stocks. The results were similar for both the pre- and post-Paris periods.
- The percentage of the norm-constrained investors (those less willing to hold sin stocks) was 22% on average for both new sin and traditional sin stocks.
- Investors in sin stocks are mainly investment managers, corporations and individuals — while new sin stocks are popular among institutional investors, traditional sin stocks are less held by norm-constrained investors. For example, government agencies have little ownership in sin stocks.
- On average, the 10 largest investors in the new sin stocks accounted for more than half the total traded shares, ranging from 52% in weapons stocks to 74% in coal stocks.
- For new sin stocks, corporation and individual investors together accounted for more than half the investors for all industries. For traditional sin stocks, individual and investment advisors together were dominant in alcohol and gambling, whereas investment advisors and hedge funds together were the major types in tobacco and weapons. All the other investor types made up relatively small shares of the investors in sin stocks, with types like sovereign wealth funds, insurance companies, and banks and trusts each making up less than 1% on average, and pension funds about 1.8% on average.
- The trends show that norm-constrained investors are slowly moving their assets from new sin stocks to the peer stocks.
Their findings led Sagbakken and Zhang to conclude: “We do not find an obvious sin premium for new sin or traditional sin stocks, either in comparison to the market or their peers in the same broad industry. At first sight, there seems to be positive alpha for traditional sin stocks, but this outperformance is resolved when controlling for more factors in Fama-French five-factor model.”
Sagbakken and Zhang’s findings provide comfort to sustainable investors, as they demonstrated that once exposure to the newer investment and profitability factors was accounted for, the alpha of sin stocks disappears. Thus, sustainable investors who tilt their portfolios to these factors can eat their cake and have it too — express their values without sacrificing returns.
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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