The Dangers of Screening Out Energy Stocks

One obvious strategy in pursuit of an environmental, social and governance (ESG) mandate is to exclude fossil fuel stocks. But new research shows this has made the portfolio vulnerable to supply or demand shocks to energy.

Concerns about climate change have led many investors, including large institutions such as the ABP and PME pension funds in the Netherlands, to sell off their entire holdings in fossil fuel stocks. Studies such as, “Fewer Reasons to Sin: A Five-Factor Investigation of Vice Stocks,” have found that stocks shunned by investors for nonfinancial reasons (commonly referred to as sin stocks, such as stocks in the tobacco, alcohol, gambling and weapons industries) have significantly outperformed the market. They have also produced significant alphas against the CAPM as well as the three-factor (beta, size and value) and four-factor (adding momentum) asset pricing models. However, the alpha disappeared when comparing returns to the newer five-factor model that includes the investment and profitability factors – their outperformance was explained by their exposures to these common factors.