Green Stocks Have Lower Returns but Less Risk
So-called “green” stocks that have a good environmental, social and governance (ESG) profile have lower expected returns. But new research shows that they also have less risk and similar risk-adjusted returns to “brown” stocks.
While sustainable investing continues 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 favored company’s share prices will be elevated, and the sin stock shares will be depressed. In equilibrium, the screening out of certain assets based on investors’ tastes should lead to a return premium on the screened assets.
The result is that the favored 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 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 return (a premium above the market’s required return) is required as compensation for the emotional cost of exposure to sin companies. On the other hand, investors in companies with higher (better) sustainability ratings are willing to accept the lower returns as the “cost” of expressing their values.
There is also a risk-based hypothesis for the sin premium. It is logical to hypothesize that companies that neglect to manage their ESG exposures are 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 lowest-scoring firms. The greater tail risk creates the sin premium.
That’s the economic theory. However, conflicting forces are at work that can lead to green stocks outperforming.
Investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainable investing scores earn rising portfolio weights, leading to short-term capital gains for their stocks – realized 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 carbon risk and returns in the short term.
James Xiong contributes to the literature with his study, “The Impact of ESG Risk on Stocks,” published in the fall 2021 issue of The Journal of Impact and ESG Investing, in which he examined the impact of ESG risk through the lens of Sustainalytics’ ESG risk-rating measure. His data sample covered U.S. stocks over the period September 2009-November 2020. Morningstar-owned Sustainalytics launched its new ESG risk-rating methodology in October 2018, and the first production appeared in September 2019 in Morningstar Direct. Thus, his dataset consisted of all U.S. stocks that received the old Sustainalytics’ best-in-class ESG ratings from August 2009-August 2019 and its new ESG risk ratings since September 2019. Following is a summary of his findings:
- Stocks in the energy sector had the highest average ESG risk rating, while stocks in the real estate sector had the lowest average ESG risk rating.
- ESG risk ratings were relatively stable over time.
- Green stocks with low ESG risk ratings tended to have higher P/Bs (they tend to be growth stocks), and brown stocks with high ESG risk ratings tended to have lower P/Bs (they tend to be value stocks).
- Green stocks were more profitable and paid higher dividends than brown stocks.
- Stocks with low ESG risk ratings (green stocks) not only had higher realized returns but also provided better tail-risk protection than stocks with high ESG risk ratings (brown stocks), especially during the COVID-19 crisis.
- Comparing Q1 (greenest) with Q5 (brownest), the annual arithmetic return was 6.8% higher (16.3 versus 9.5), the standard deviation was 3.7% lower (14.5 versus 18.2) and the Sharpe ratio was 0.6 higher (1.1 versus 0.5).
- Brown stocks (Q5) suffered the worst monthly tail loss (-9.1%), whereas green stocks (Q1) suffered the least (-6.6%). In addition, the maximum drawdown was the smallest for Q1 (-18.9%) and the largest for Q5 (-37.6%).
- The tail-risk protection provided by green stocks was robust within sectors and styles.
- Sectors played an important role in explaining returns, as the energy sector accounted for the main part of the underperformance for brown stocks. When excluding stocks in the energy sector, the outperformance of green stocks shrunk, though they still provided meaningful tail-risk protection.
- Green mutual funds and exchange-traded funds (ETFs) that held green stocks attracted significantly more fund flows than their counterparts, which is associated with the outperformance for both green funds and stocks – fund flows are associated with persistent fund performance and stock price momentum.
In addition to the increased cash flows into green stocks, which helped their performance, green stocks tend to be more growth oriented. Since growth outperformed value during the sample period, it helps explain green outperformance even though brown stocks had an ex-ante premium.
Xiong’s findings of significantly reduced tail risk are consistent with findings from prior research, including the 2019 study, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance,” and the 2021 study, “Sustainable Systematic Credit.” That’s good news for sustainable investors because even though ex-ante green stocks have lower expected returns, their risk-adjusted returns are not necessarily lower – the reduction in risk offsets the lower expected returns. In addition, research, including the 2017 study, “Fewer Reasons to Sin: A Five-Factor Investigation of Vice Stocks,” and the 2020 study, “Carbon Risk,” found that while vice or sin (brown) stocks outperform versus a three-factor (beta, size and value) model, the alpha disappears when the benchmark is a five-factor (adding investment and profitability) model. Thus, by tilting their portfolios to factors that have historically provided premiums, sustainable investors can live their values without negatively impacting the ability to achieve their financial goals.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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