Does ESG/SRI Investing Reduce Stock Prices and Investment Returns?

Sustainable investment encompasses a combination of the following activities and strategies:

1. Negative/exclusionary screening: The exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria. These assets are usually associated with controversial industries such as the alcohol, tobacco, gaming, and defense industries, which are also sometimes called “sin” industries.

2. Positive/best-in-class screening: Investment in sectors, companies or projects selected for positive ESG performance relative to industry peers.

3. Norms-based screening: Screening of investments against minimum standards of business practice based on international norms, such as those issued by the OECD, ILO, UN and UNICEF.

4. ESG integration: The systematic and explicit inclusion by investment managers of environmental, social and governance factors into financial analysis, leading to overweighting assets with high environmental, social and governance scores, or symmetrically, underweighting those with poor scores.

5. Sustainability themed investing: Investment in themes or assets specifically related to sustainability (for example clean energy, green technology or sustainable agriculture).

6. Impact/community investing: Targeted investments aimed at solving social or environmental problems, and including community investing, where capital is specifically directed to traditionally underserved individuals or communities, as well as financing that is provided to businesses with a clear social or environmental purpose.

7. Corporate engagement and shareholder action: The use of shareholder power to influence corporate behavior, including through direct corporate engagement (i.e., communicating with senior management and/or boards of companies), filing or co-filing shareholder proposals, and proxy voting that is guided by comprehensive ESG guidelines.

Of these seven, the largest sustainable investment strategy globally is negative/exclusionary screening (about $20 trillion), followed closely by ESG integration. Corporate engagement/shareholder action accounts for almost $10 trillion, and norms-based screening accounts for almost $5 trillion.

While providing the benefit of being able to express their social views, given the large amount of assets committed to ESG strategies, investors should also be concerned about the potential impact these strategies have on stock prices and, thus, performance.

Economic theory

Economic theory suggests that, if a large enough proportion of investors choose to avoid the stocks of companies with low ESG ratings, the share prices of such companies will be depressed – they will have a higher cost of capital, trading at lower price-to-earnings ratio. Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies). Thus, the so-called sin stocks should outperform the ESG-favored stocks.

In a March 2018 article, I reviewed the evidence supporting the economic theory. And in an April 2019 article, I showed that three ESG indices underperformed their non-ESG counterparts, confirming economic theory.

Latest research

Olivier Zerbib contributes to the literature on ESG investing with his September 2019 study “ A Sustainable Capital Asset Pricing Model (S-CAPM): Evidence from green investing and sin stock exclusion.” His goal was to determine how sustainable investing through exclusionary screening and ESG integration affects asset returns. He developed an asset pricing model with a premium on neglected stocks (limited investor participation in financial markets entails an additional risk premium on the expected returns on neglected stocks) and a taste premium (induced by sustainable investors’ tastes for assets related to the cost of externalities that they internalize). Both exclusion premia result from the reduction of the investor base. He then applied the model to green investing and sin stock exclusion using U.S. data between 2000 and 2018. His data sample included 348 green funds worldwide investing in U.S. equities as of December 2018. The following is a summary of his findings:

• The S-CAPM model outperforms the Carhart four-factor model (market beta, size, value and momentum). Consistent with economic theory the model yields a taste and an exclusion effect of 1.5% and 2.5% per year (and statistically significant), respectively.

• Premiums increase when a group of investors is pessimistic about this asset and vice versa when it is optimistic.

• Sustainable investors make a sub-optimal choice when they construct portfolios with lower Sharpe ratios than that of the mean-variance portfolio.

Conclusion

The development of sustainable asset management is an effective means of encouraging companies to embrace change because it leads to an increase in the cost of capital for the least virtuous companies. With that in mind, the evidence does make clear that investors should explicitly recognize the tradeoffs between ESG goals and financial returns.

While ESG investing continues to gain in popularity, economic theory suggests, and the evidence demonstrates, that, if a large enough proportion of investors chooses to avoid the stocks of companies with low ESG ratings, the share prices of such companies will be depressed. Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies). With this knowledge, investors are positioned to pursue their financial goals in the manner that reflects their values and the costs they are willing to bear to achieve those values.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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