Over the past decade, and particularly over the last several years, there has been a dramatic increase in environmental, social and governance (ESG) investing strategies. That has coincided with robust economic and market performance in the U.S. New research examines whether strong ESG returns are likely to be tied to a strong economy and market.
ESG investing (also known as sustainable or socially responsible investing [SRI]) now accounts for more than one-fourth of total assets under management (AUM) in the U.S., with AUM growing to $12 trillion, up 38% from the start of 2016 to the start of 2018. Total assets with a sustainable investing mandate exceeded $30 trillion globally at the start of 2018, with institutions accounting for 75% of the total.
The trend is poised to continue.
Increased investor interest has not only led to cash inflows but to heightened interest in research on ESG investment strategies. Lubos Pastor, Robert Stambaugh and Lucien Taylor contribute to the literature with their December 2019 paper, Sustainable Investing in Equilibrium. They analyzed both financial and real effects of sustainable investing through the lens of a general equilibrium model that “illuminates the key channels through which agents’ preferences for sustainability can move asset prices, tilt portfolio holdings, determine the size of the ESG investment industry, and cause real impact on society.” Their model “implies three-fund separation, whereby each agent holds the market portfolio, the risk-free asset, and an ‘ESG portfolio,’ which is largely long green assets and short brown assets. Agents with stronger-than-average ESG preferences go long the ESG portfolio, whereas agents with weaker preferences go short. Agents with average ESG preferences hold the market portfolio.”
Following is a summary of their key conclusions:
- Firms differ in the sustainability of their activities. “Green” firms generate positive externalities on society, “brown” firms generate negative externalities, and there are different shades of green and brown.
- Agents differ in their preferences for sustainability, or “ESG preferences.” These preferences have two dimensions. Agents derive utility from holdings of green firms and disutility from holdings of brown firms. Second, though they care about firms’ aggregate social impact, they also care about financial wealth. However, they are willing to sacrifice some expected return in exchange for the utility benefits provided by green investing.
- Agents’ tastes for green holdings affect asset prices – the greener the asset, the lower its capital asset pricing model (CAPM) alpha in equilibrium. Green assets have negative alphas and brown assets have positive alphas. Consequently, agents with stronger ESG preferences, whose portfolios tilt more toward green assets and away from brown assets, earn lower expected returns.
- Sustainable investing leads to positive social impact through its impact on asset prices. By pushing green asset prices up (lowering the cost of capital) and brown ones down (raising the cost of capital), agents’ tastes for green holdings induce more investment by green firms and less investment by brown firms. The more agents care more about ESG, the greater the positive social impact.
- If ESG concerns strengthen unexpectedly, green assets can outperform brown assets despite having lower expected returns. The higher short-term returns are a result of the increased cash flows on valuations. “Exposure to ESG risk is why green assets may outperform brown assets over a period of time.” Investor tastes/preferences can drive short-term returns through changes in valuations. Thus, the premium induced by exposure to the ESG risk factor can be large enough to overcome green stocks’ negative alphas.
- There is an ESG risk factor as the strength of ESG concerns can change over time, both for investors in firms’ shares and for the customers who buy the firms’ goods and services. If ESG concerns strengthen, customers may shift their demands for goods and services to greener providers (the “customer” channel), and investors may derive more utility from holding the stocks of greener firms (the “investor” channel). Greener stocks are more exposed to the ESG risk factor.
Pastor, Stambaugh and Taylor also noted that Ravi Bansal, Di Wu and Amir Yaron, authors of the September 2019 study, Is Socially Responsible Investing A Luxury Good?, concluded that green stocks outperform brown stocks in good times but underperform in bad times. Those authors argued that “green stocks are similar to luxury goods in that they are in higher demand when the economy does well and thus financial concerns matter less.” This is consistent with a wealth-dependent investor preference that is more favorable toward ESG/SRI during good times (when risk aversion is low), resulting in higher temporary demand for those strategies. It is similar to the time-varying shifts exhibited in the demand for luxury goods. Thus, we can see how time-varying preferences can cause green stocks to outperform over some periods, even though they have lower expected returns.
Summary
Pastor, Stambaugh and Taylor’s conclusions are all economically intuitive. Summarizing, they find that “investors with stronger-than-average ESG sensitivities hold portfolios that have a green tilt away from the market portfolio, whereas investors with weaker-than-average ESG sensitivities have a brown tilt. These tilts are larger when risk aversion is lower. Investors with stronger ESG sensitivities earn lower expected returns, especially when risk aversion is low and the average ESG sensitivity is high.”
They also found that, from the perspective of ESG investors, “sustainable investing leads to positive social impact by inducing more investment by green firms and less investment by brown firms. Greener firms invest more, especially when risk aversion is low, the average ESG sensitivity is high, and when stock prices have a larger effect on firms’ investment.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
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