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Expected Return on ESG Excluded Stocks –


As Sam Adams and I explain in our new book, “Your ultimate guide to sustainable investing”, while sustainable investing continues to gain popularity, economic theory suggests that if a large enough proportion of investors favor companies with high sustainability ratings (green businesses) and avoid companies with low sustainability ratings (brown or brown businesses), then price preference on company shares will be raised and excluded shares will be lowered. In equilibrium, the selection of certain assets based on investor preferences/tastes should lead to a premium on the return on the tested assets.

As a result, preferred companies will have a lower cost of capital because they will trade at higher price-to-earnings (P/E) ratios. The downside of a lower cost of capital is a lower expected return for the providers of that capital (shareholders). Coupled with this idea, sinful companies will have a higher cost of capital because they will trade at lower P/E ratios, the flip side of which is a higher expected return for the providers of that capital. The hypothesis is that the expected return is higher(1) are claimed as compensation for the emotional cost of exposure to offensive campaigns. On the other hand, investors in companies with higher sustainability ratings are willing to accept lower returns as the cost of expressing their value. There is also a risk-based hypothesis for the premium for sin. It is logical to assume that companies that neglect environmental, social and governance (ESG) management may be at greater risk (2) than their more ESG-focused peers. The argument is that companies with high sustainability scores have better risk management and better compliance standards. Stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption, and lawsuits (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. Greater tail risk creates a sin premium.

In addition, sustainable investors sacrifice some of the diversification benefits of a broad market index fund because their investments are limited to a set of stocks that meet the sustainable investment selection process. Intuitively, less diversified portfolios are less efficient because exclusions reduce the possible set of investment portfolios (ESG investors have less diversified portfolios), which worsens the risk/return ratio.

Our book provides an in-depth analysis of empirical research findings, reviewing dozens of papers that demonstrate support for both benefit/taste and risk theory explanations of the sin premium. The book also goes into great detail about the impact of a sharp increase in cash flow from sustainable investors on returns. These cash flows create conflicting forces as investor preferences lead to different short- and long-term impacts on asset prices and returns. Companies with high sustainable investment scores receive an increase in portfolio weighting, resulting in short-term capital gains for their shares – realized returns are temporarily increased. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in the return on green assets, even though brown assets have higher expected returns. In other words, there may be an ambiguous relationship between carbon risk and returns in the short term.

New evidence

Erika Berle, Wangwei He and Bernt Edegaard contributed to the sustainable investment literature with their research in May 2022. “Expected return on ESG-excluded stocks. The case of exclusion from the Petroleum Fund of Norway,” in which they analyzed the implications of a broad ESG-based portfolio exclusion on the expected returns of excluded firms. They took exception to Norway’s Government Pension Fund Global (GPFG), the world’s largest sovereign wealth fund with an equity portfolio valued at $1 trillion at the end of 2021, whose ESG decisions are used as a model for many institutional investors.

The ethical guidelines used for exemptions are defined by the Norwegian Ministry of Finance and contain both product exemptions (currently including tobacco, hemp, some weapons and coal) and conduct-based exemptions (currently including human rights violations , damage to the environment, unacceptable levels of greenhouse gas emissions, corruption and arms sales to certain states). Berle, He, and Edegaard constructed different portfolios representing GPFG exclusions—portfolios were constructed for all excluded stocks and exclusion reasons. They measured performance as alpha relative to global five-factor model of Fama and French. Their data sample spanned the period 2005-2022, with a total of 189 companies excluded over different periods.

Below is a summary of their findings:

  • The excluded portfolios (firms with a low ESG score) performed significantly better (alpha) compared to the Fama-French five-factor model. For example, an equally weighted portfolio of all excluded stocks had a statistically significant annualized alpha of nearly 5%. The US portion of the exceptions portfolio had an even higher 5.7% alpha. Value-weighted alphas were even higher at nearly 7% for the global portfolio. Alphas were significant at the 1% confidence level.
  • Equally weighted, the excluded portfolio was exposed to size and value factors, while the value-weighted excluded portfolio had negative exposure to the size factor but positive exposure to the value factor.
  • The excluded portfolio had less systematic risk than the market – the market beta was below 1.
  • Alpha coefficients for behavior-based portfolios are twice the alphas for product-based portfolios.
  • The results were robust to alternative factor models, including one-factor capital asset pricing (market beta), three-factor (adding size and value), and four-factor (adding momentum) models, subperiods, and other tests.
The results are hypothetical results and are NOT indicative of future results and do NOT represent the returns actually achieved by any investor. The Indices are not managed, reflect no management or trading fees, and cannot be invested directly in the Index.

Their conclusions led Berle, He and Edgar conclude:

“The very magnitude of excess returns (5% annualized) leads us to conclude that short-term price pressures cannot be the only explanation for our results, the expected returns of excluded firms should be higher in the long run.”

They added:

“One way to interpret the results is to think in terms of the equilibrium cost of capital. Companies with such poor ESG ratings that they are excluded from the GPFG may face an uphill battle to raise capital for new investment. Therefore, they must offer higher returns to investors willing to get their hands dirty by providing capital. From a societal perspective, this is a good thing, higher capital costs will actively discourage investment in low-rated ESG projects, as fewer projects will be able to sustain such high returns. … Thus, brown firms will face higher barriers than green firms when financing new investments. These brown firms would then have an incentive to become greener in order to gain access to cheaper capital. On balance, this will be a real trade-off, and future investments will be greener.”

Takeaways for investors

Empirical evidence clearly demonstrates that exclusions lead to ex ante premiums for excluded stocks. Berle, He, and Edegaard found that just under 200 stocks excluded from the GPFG produced significantly higher returns (alpha). Those investors who only care about income might consider creating a “vice” portfolio and then, if they choose, donate the higher expected returns directly to causes they care about. Those investors who want to express their value through their investments should keep in mind that excluded stocks represent a very small proportion of all stocks and a small percentage of the total market capitalization, which means that excluding stocks does not reduce portfolio returns by about 5%, found By Berl, He and Edegaard. For example, a 2017 study found that exclusions reduced the Norwegian fund’s return by 1.1% over the previous 11 years.

Investors should also note that empirical research has shown that the excess returns of excluded stocks are accompanied by greater risk for these companies. As discussed in Your Ultimate Guide to Sustainable Investing, stocks with low ESG scores have greater risk, including potential legislation that could lead to asset destruction, potential consumer boycotts, fraud due to poor risk controls, poor governance, scandals with human rights and environmental scandals. As a result, they have less risk of an accident. In other words, these higher returns aren’t free lunches, but they do at least partially offset the higher risks

Finally, investors should note that since 2018, when cash flows in sustainability strategies have increased dramatically, there have been conflicting forces at work that have led green stocks to outperform brown stocks’ expected returns.

Conflicting forces

Given the trend toward sustainable investing, firms with high sustainability scores receive increasing portfolio weightings, resulting in short-term capital gains for their stocks—realized returns temporarily increase. Therefore, the result may be an increase in the return on green assets, even if brown assets have a higher expected return. For example, the authors of a 2022 study “Dynamic ESG balance» It found that despite investor preferences for sustainable investments generating a brown premium of around 1 per cent per annum, increased demand for sustainable investments over the period 2018-2020 resulted in the green portfolio outperforming by around 7 per cent points per year (14 percent versus 7 percent per year). percent). However, the long-term effect is that higher valuations reduce expected long-term returns.

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information is believed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become obsolete or otherwise replaced without notice. By clicking on any of the above links, you acknowledge that they are provided solely for your convenience and do not necessarily imply any association, sponsorship, endorsement or endorsement on our part with respect to the third party websites. We are not responsible for the content, availability or privacy policies of these sites, nor are we responsible for any information, opinions, advice, products or services available on or through them. The opinions expressed by the featured authors are their own and may not necessarily reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively known as Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy of, or confirmed the quality of this article. LSR-22-296

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