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.
David Blitz examined the impact on the systematic risks of portfolios that screen out fossil fuels in his December 2021 paper, “Betting Against Oil: The Implications of Divesting from Fossil Fuel Stocks.” Instead of focusing on asset pricing models, he focused on exposure to macroeconomic risk factors that explained large differences in short- and medium-term returns. He used the energy sector as a proxy for the stocks that are targeted by fossil fuel divestment. His data sample covered the period January 1995 to September 2021. Following is a summary of his findings:
- The energy sector had an equity beta of about 0.8 and a bond beta of about -0.1.
- Fossil fuel stocks exhibited a highly significant positive exposure toward changes in the oil price.
- The energy sector outperformed or underperformed by about 20% per annum during an energy bull versus bear market – it outperformed strongly during oil bull markets (excluding it from 2001 to 2010 reduced portfolio return by about 1.25% per year) and underperformed strongly during oil bear markets (excluding it from 2011 to 2020 improved portfolio return by almost 1% per year).
- Within the equity market, the materials sector (such as mining stocks) appeared to have offered the best hedge for fossil fuel stocks (it was the only sector with a significantly positive oil beta, about one third [0.06] that of the oil beta of energy stocks [0.21]). However, this sector tended to have both a high carbon footprint and environmental issues.
- Oil futures could be a direct hedge but may be even less acceptable to investors who do not want fossil fuel exposure.
His findings led Blitz to conclude: “Excluding fossil fuel stocks comes down to an active bet against the oil price, which makes a portfolio vulnerable to significant underperformance in the short and medium term.”
Investor takeaway
The research on asset pricing suggests that investors who want to exclude fossil fuels from their portfolios can “have their cake and eat it too” by tilting their portfolios to the common factors (beta, size, value, momentum, profitability/quality and investment). However, there are two caveats. While divesting from fossil fuel stocks appears to have had a neutral effect on long-term expected returns, it has made a portfolio vulnerable to significant underperformance during oil or energy rallies that can take place in the short and medium term. Second, if enough investors screen out/sell off fossil fuel stocks, their cash flows can lead to lower valuations, causing capital losses in the short term while raising future expected returns.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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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.
