An Ominous Sign for ESG Investors

Contrary to economic theory, in recent years funds with an environmental, sustainability and governance (ESG) mandate have outperformed the broader market. New research shows that from 2016 to 2021, the outperformance was caused by increased asset flows to so-called green stocks, raising the prospects for lower returns going forward.

The sustainable investment industry has experienced dramatic growth in the last decade. The high demand for sustainable investments, fueled by rising environmental concerns, has generated the emergence of new ESG funds and has led existing funds to incorporate ESG concerns into their prospectuses. According to Morningstar’s Global Sustainable Fund Flows Report, in the first quarter of 2021, over $180 billion flowed to sustainable funds globally. The assets managed by sustainable mutual funds and ETFs alone amounted to over $2 trillion dollars1.

What is the impact of sustainable investing on asset prices and expected returns?

Economic theory

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” or “brown” businesses), the favored company’s share prices will be elevated. and the sin/brown stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium for 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 returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainable ratings are willing to accept the lower returns as the “cost” of expressing their values.