The popularity of environmental, social and governance (ESG) investing strategies has driven up the valuations of those stocks. New research shows that ESG investors should brace themselves for lower returns – and that underperformance may come at the worst possible time.
Over the past decade, there has been an accelerating increase in ESG strategies. In fact, ESG (also known as sustainable investing or socially responsible investing [SRI]) now accounts for one out of every four dollars under professional management in the United States and one out of every two dollars in Europe.
The trend is poised to continue.
Increased investor interest has not only led to cash inflows but also to heightened interest in research on ESG investment strategies. Rocco Ciciretti, Ambrogio Dalò and Lammertjan Dam contribute to the literature with their December 2019 study “The Contributions of Betas versus Characteristics to the ESG Premium.” They note that the incorporation of ESG characteristics in investment decisions can impact expected returns by reflecting investor preferences or by “loading” on an underlying risk factor. Either way, they suggest a likely ESG premium on expected returns. They explained: “Systematically lower demand should lead to a systematically lower price and thus a higher dividend-price ratio. Even if responsible firms encounter higher operating costs, investors’ preferences for SRI may make them willing to invest in such firms, despite the threat of lower returns.”
The authors used two global data sets covering almost 6,000 firms for the period 2004 through 2018. As asset pricing models, they considered the CAPM (a single factor of market beta), the global Fama-French three- (beta, size and value) and five-factor (adding investment and profitability) models, augmented versions of these models that include momentum, and an ESG risk factor. Following is a summary of their findings:
- Firms with lower ESG scores exhibit higher expected returns – the average excess return decreases as the ESG score increases, though not monotonically.
- The market capitalization of the best portfolio (firms with the highest ESG score) is the largest of the 10 decile portfolios, much larger than that of the worst (firms with the lowest ESG scores).
- The market capitalization weight of the best portfolio increases over time, which might be a reflection of the increase in demand for responsible assets.
- The premium on the ESG characteristic is negative and significant for all model specifications, including the seven-factor model that controls for ESG risk exposure.
- The negative premium is driven mainly by ESG characteristics, not ESG risk factor betas (which are insignificant). This means that the lower returns for ESG stocks are due to their ESG characteristics, rather than some other risk factor.
- A one standard deviation decrease in ESG characteristic is associated with an increase in expected returns of 13 basis points on a monthly basis.
- Their results were supported by various tests of robustness.
Based on an equilibrium model, Ciciretti, Dalò and Dam concluded that their results indicate that the cross-sectional variation of expected returns related to the ESG premium is mainly driven by investor preferences for ESG-related issues rather than that systematic risk components are captured by ESG scores. In other words, asset flows to ESG stocks have driven down expected returns.
They added: “Irrespective of risk considerations, investors are willing to forgo potential returns if a firm scores well on ESG items (or alternatively, investors are only willing to hold firms that score low on ESG items if they are compensated with higher returns).” This is the same conclusion reached by Lubos Pastor, Robert Stambaugh and Lucian Taylor, authors of the December 2019 paper, “Sustainable Investing in Equilibrium.” Both sets of authors noted that with the increased demand toward ESG funds, the expected equilibrium has likely shifted. Firms with high ESG scores have rising portfolio weights, leading to short-term capital gains for their stocks – realized returns may rise temporarily, though expected long-run returns fall. Ciciretti, Dalò and Dam investigated how the long-run ESG premium evolves over time by running regressions of dividend-price ratios on the ESG characteristics and confirmed this hypothesis.
Summary
Investors use ESG characteristics in their decisions for two different reasons: ESG characteristics reflect their preferences, unrelated to risk and return; or those investors want to load on some underlying risk factor. Either way, these motivations potentially lead to an ESG premium on expected returns. However, the ESG premium is time varying. The heightened demand for ESG investments has led to rising valuations of stocks with high ESG scores relative to stocks with low ESG scores, producing short-term capital gains and blurring the expected negative premium.
But, the short-term benefit comes at the expense of now lower long-term expected returns.
Since it is likely that the trend favoring ESG investing will continue, the “price” ESG investors pay for expressing their social views through their investments, in the form of lower expected returns, might be offset (at least to some degree) by continued rising valuations. However, what cannot continue forever eventually ceases. With this in mind, investors should be aware of the findings of Ravi Bansal, Di Wu and Amir Yaron, authors of the September 2019 study “Is Socially Responsible Investing A Luxury Good?” They concluded that green stocks outperform brown stocks in good times but underperform in bad times. They argued that “green stocks are similar to luxury goods in that they are in higher demand when the economy does well and thus financial concerns matter less.” This is consistent with a wealth-dependent investor preference that is more favorable toward ESG during good times (when risk aversion is low), resulting in higher temporary demand for ESG. This is similar to the time-varying shifts exhibited in the demand for luxury goods. Thus, we can see how time-varying preferences can cause green stocks to outperform over some periods, even though they have lower expected returns. It also demonstrates that the risks to ESG investors might show up at the worst possible time, during a bear market when labor capital is also at risk.
If you have high risk aversion, like most investors, the risk that ESG investments will perform poorly in bad times should be considered when deciding on your investment strategy.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
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