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.
There is also a risk-based hypothesis for the sin premium. It is logical to hypothesize that companies neglecting to manage their ESG exposures could be 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 the lowest-scoring firms. The greater tail risk creates the sin premium. The risk-based explanation means that while sustainable investors should expect lower returns, they also incur less risk. Thus, risk-adjusted returns should be similar.
While economic theory clearly posits that investors should expect to earn lower returns for expressing their views, sustainable funds have performed well in recent years, suggesting that ESG-concerned investors are in fact “doing well by doing good.”
What’s the explanation for the gap between economic theory and empirical findings?
Conflicting forces
The divergence between economic theory and empirical findings can be explained by the fact that investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainability 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 can be an ambiguous relationship between ESG risks and returns in the short term. Without this understanding, investors can misinterpret findings that appear to show a lack of a brown premium – the realized returns to green stocks can be higher if green tastes (such as climate concerns) strengthen unexpectedly over time. This divergence between realized and expected returns can explain the ambiguity in the empirical findings. In other words, there was an ex-ante brown premium, but the ex-post results showed a negative premium because of cash flows raising valuations of green companies. And because sustainable investors likely have a high degree of price inelasticity, flow-induced price pressures have a large impact on valuations and thus returns.
Flows jave affected returns to green and brown stocks
Philippe van der Beck contributes to the sustainable investing literature with his September 2021 study, “Flow-Driven ESG Returns,” in which he used quarterly data on mutual fund holdings to construct a representative ESG portfolio that pooled the holdings of U.S. equity mutual funds that have a sustainability mandate. The ESG portfolio’s deviations from market weights were then used to construct a stock-level taste characteristic that measured investors’ perceived sustainability of a stock. He then estimated investor-specific elasticities of substitution (ease with which one can switch between similar products) using 13F holdings. His data sample covered the period 2000-2020. Following is a summary of his findings:
- The performance of ESG investments was strongly driven by price pressure arising from unanticipated flows toward sustainable funds, causing high realized returns that did not reflect high expected returns.
- The coefficient linking ESG flows and realized returns is the product of two factors: the deviation of green funds’ portfolios from the market portfolio and a flow multiplier matrix that is the inverse of the market’s demand elasticity of substitution between stocks.
- Between 2016 and 2021, the ESG-taste portfolio earned a 2.6 percentage points higher annualized return than the market portfolio – investors were rewarded instead of penalized for investing according to their ESG preferences.
- Withdrawing $1 from the market portfolio and investing it in the representative ESG fund increased the aggregate value of high-ESG-taste stocks by $2-2.50.
- The price pressure arising from quarterly flows of only $5 billion was sufficient to account for all the outperformance of ESG funds over the market portfolio in recent years.
- In the absence of flow-driven price pressure, the aggregate ESG industry would have strongly underperformed the market from 2016 to 2021, and the positive alpha of a long-short ESG-taste portfolio becomes significantly negative.
Van der Beck’s finding that withdrawing $1 from the market portfolio and investing it in the representative ESG fund increases the aggregate value of high ESG-taste stocks by $2-2.50 (showing markets are inelastic) is consistent with the findings of two 2021 studies. Xavier Gabaix and Ralph Koijen, authors of the study “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” found that investing $1 in the stock market increases the market’s aggregate value by about $5; and Samuel Hartzmark and David Solomon, authors of the study, “Predictable Price Pressure,” which focused on dividends, found price-pressure multipliers of between 1.5 and 2.3.
Van der Beck’s findings led him to conclude: “High realized returns to sustainable equity investing over the past decade are primarily flow-driven and should hence not be interpreted as expected returns going forward.” He added: “Without a continued money flow into sustainable funds, ESG investing has negative expected returns.”
Investor takeaway
Given the continued trend in sustainable investing, it will be a while before we reach a new equilibrium. In addition, if climate risks increase unexpectedly, the hedging benefits of holding green stocks would improve, pushing up their price, resulting in higher realized returns (the reverse would also be true if the perception of climate risks decrease). Thus, unexpected shifts in the aggregate demand for green assets may drive a wedge between expected and realized returns. In the meantime, despite investors requiring a risk premium for owning brown stocks, green stocks can outperform brown ones.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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1This narrative has been challenged.
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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.
