Sustainable investing continues to gain in popularity, with investors worldwide frequently attracted not only by ethical concerns but also by the lure of superior returns. Unfortunately, new research focused on global stocks showed that they did not get what they were sold.
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Economic theory suggests that if a large enough proportion of investors choose to favor companies with high sustainability ratings (green businesses) and avoid those with low sustainability ratings (brown, or sin, businesses), the favored companies’ share prices will be elevated, and the excluded shares will be depressed. Thus, in equilibrium, the screening out of certain assets based on investors’ preferences/tastes should lead to a return premium on those assets.
As Sam Adams and I explained in our new book, Your Essential Guide to Sustainable Investing, the evidence has generally been consistent with economic theory. For example, Erika Berle, Wangwei He and Bernt Ødegaard, authors of the April 2022 study, “The Expected Returns of ESG Excluded Stocks. The Case of Exclusions from Norway's Oil Fund,” analyzed the consequences of widespread environmental, social and governance (ESG)-based portfolio exclusions on the expected returns of firms subject to exclusion and found that exclusion portfolios (low ESG-scoring firms) had significant superior performance (alpha) relative to a Fama-French five-factor model. For example, the equally weighted portfolio of all excluded stocks had a statistically significant annual alpha of almost 5%. As another example, a 2017 study found that exclusions had reduced the return to the Norway fund by 1.1% over the prior 11 years.
While excluded (low ESG-scoring) stocks have produced lower returns, the picture is not all one-sided, as the excluded stocks are likely to be subject to greater risk because companies with high sustainability scores have better risk management and better compliance standards. Their 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.
Read the full article here by Larry Swedroe, Advisor Perspectives.
