Impact investing seeks to achieve social good, but new research show that it has had a negligible effect on the cost of capital for so-called “brown” companies.
Impact investments are made to generate positive, measurable social and environmental impact alongside a financial return. The growing impact investment market provides capital to address the world’s most pressing challenges in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services including housing, healthcare and education. Divestment (not investing in or selling stocks in companies that impose social and environmental costs) is one tool investors can employ to achieve this goal.
Jonathan Berk and Jules van Binsbergen contribute to the impact investing literature with their September 2021 paper, “The Impact of Impact Investing.” They began by noting: “When a socially conscious shareholder sells her stake to another shareholder, the new shareholder needs to be induced into buying shares in the company. This inducement comes in the form of a lower price. The lower price implies a higher cost of capital which affects the company’s future real investment strategy by lowering the number of positive net present value (NPV) investment opportunities, thus lowering the company’s growth rate. The opposite is true when a socially conscious shareholder chooses to buy. The extra demand for clean companies increases the price of those companies, lowering the cost of capital and thus increasing their growth rates. In the long term, socially desirable companies become a larger fraction of the economy at the expense of socially undesirable companies and the social and environmental costs on society are reduced. Therefore, for divestiture to have impact, it is essential that the divestment strategy results in a large enough change in the cost of capital to materially affect the firm’s investment opportunity set.”
With the theory in mind, the authors set out to evaluate the impact of divestiture initiatives by determining whether they have materially affected the cost of capital and, if not, whether they are likely to do so in the future. Using the largest socially conscious index fund, they estimated that the fund targeted companies that made up about 50% of the economy (and those stocks had a correlation of 0.97 to the market). They also estimated (using the fraction of mutual fund wealth invested in ESG mutual funds) that socially conscious wealth makes up about 2% of the total market capitalization. They then assumed a 6% equity risk premium. Based on these assumptions, they estimated that the effect of impact investors on a company’s cost of capital was only about 0.35 basis points. They added: “Given the uncertainty in the capital budgeting process, one third of a basis point cannot meaningfully impact firms’ investment strategies.”
By studying the effect of a firm being either included or excluded from the FTSE USA 4 Good Index (the world’s largest socially responsible index fund, the Vanguard FTSE Social Index Fund, with about $15 billion in assets as of September 2021, tracks this index), they then showed that the empirical data was consistent with their theoretical prediction. They found: “Even with the growth in the popularity of impact investing in the last 10 years, they found no detectable difference in the cost of capital between firms that were targeted for their social or environmental costs and firms that were not.” Summarizing, they stated: “In line with our theory, we find that the effect of a change in social status of a firm is very small and not statistically different from zero.”
Berk and van Binsbergen also considered what it would take for a divestment strategy to successfully impact firm investment: “Using the most optimistic estimates, we show that to effect a more than 1% change in the cost of capital, impact investors would need to make up more than 80% of all investable wealth. Given the low likelihood of achieving such a high participation rate, the results in this paper question the effectiveness of disinvestment.” Summarizing, they stated: “The reason divestiture has so little impact is that stocks are highly substitutable, and socially costly stocks make up less than half of the economy. It therefore does not take much of a price change to induce an investor who does not care about the social costs to hold more of a stock than they otherwise would. To put this in the language of modern finance, when socially responsible investors divest, they must induce other investors to move away from their fully diversified portfolio. But because the fraction of stocks that are subject to divestment is small enough relative to the supply of investable capital and stocks are highly correlated with each other, the new portfolio is only slightly less diversified than the old one. So the new investors do not demand much of an increase in their expected return. Thus, the effect on the cost of capital is small. The only way to materially affect this basic trade-off is for most investors to choose to divest. In this case, because the shareholders that must hold the targeted stocks comprise only a small minority of shareholders, they must be induced to hold a more highly concentrated portfolio which materially affects their overall diversification. In equilibrium this causes a larger price impact.” They added: “One implication of our paper is that investors are likely to be more effective in reducing social costs by investing, rather than disinvesting, in socially costly firms and using their rights of control to alter corporate policy.”
While Berk and van Binsbergen found that divestment by sustainable investors was not likely to have much of an impact on a company’s cost of capital, the research shows there has been a “sin” premium. For example, the authors of the 2019 study, “The Contributions of Betas versus Characteristics to the ESG Premium,” found that firms with lower ESG scores exhibit higher expected returns – companies pay a price in the form of a higher cost of capital – with the premium driven mainly by ESG characteristics. The authors found that a one-standard-deviation decrease in ESG characteristics was associated with an increase in expected returns of 13 basis points on a monthly basis. And research, such as the 2019 study “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance,” has found that companies with strong ESG profiles are less vulnerable to systematic market shocks because they have above-average risk control and compliance standards across the company and within their supply chain management. And because of better risk-control standards, high ESG-rated companies suffer less frequently from severe incidents such as fraud, embezzlement, corruption or litigation cases that can seriously impact the value of the company and therefore the company’s stock price. The result is that they experience less frequent risk incidents, leading to less stock-specific downside or tail risk in their company’s stock price. Lower systematic risk leads to lower market betas, and thus they have lower costs of capital.
In other words, investor tastes or preferences, which lead to divestment, don’t necessarily cause higher costs of capital for brown, or sin, stocks. Simple risk-based explanations and/or exposure to common factors can lead to a premium. For example, Greg Richey, author of the 2017 study “Fewer Reasons to Sin: A Five-Factor Investigation of Vice Stocks,” covering the period October 1996 to October 2016, employed several factor models to determine whether a portfolio of vice stocks outperformed the S&P 500 (a benchmark to approximate the market portfolio) on a risk-adjusted basis. He measured the performance of vice stocks using the single-factor CAPM model (market beta), the original Fama-French three-factor model (adding size and value), the Carhart four-factor model (adding momentum) and the newer Fama-French five-factor model (market beta, size, value, profitability and investment). His dataset included 61 corporations from vice-related industries. Following is a summary of his findings:
- For the period October 1996 through October 2016, the S&P 500 returned 7.8% per annum. The “vice fund” returned 11.5%.
- All models, including the Fama-French five-factor model, demonstrated that the Vice Fund portfolio beta was between 0.59 and 0.74, indicating that the vice portfolio exhibited less market risk or volatility than the S&P 500 Index, which had a beta of 1 over the sample period, reinforcing the defensive nature of sin portfolios.
- The annual alphas (returns above the risk-adjusted benchmark) on the CAPM, three-factor and four-factor models were 2.9%, 2.8% and 2.5%, respectively. All were significant at the 1% level. These findings suggest that vice stocks outperformed on a risk-adjusted basis. However, in the five-factor model, the alpha virtually disappeared, falling to just 0.1% per year. This result helps explain the performance of vice stocks relative to the market portfolio that previous models failed to capture. The r-squared figures ranged from about 0.5 to about 0.6. Richey concluded that the reason for the higher returns to vice stocks is because they are more profitable and less wasteful with investments than the average corporation.
Richey’s findings are consistent with other studies on sin stocks, such as the 2009 study, “The Price of Sin: The Effects of Social Norms on Markets.” The authors found that for the period 1965 through 2006, a U.S. portfolio long sin stocks and short their comparables had a return of 0.29% per month after adjusting for the four-factor model. As out-of-sample support, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a year. The authors concluded that the abnormal risk-adjusted returns of vice stocks were due to neglect by institutional investors, who lean on the side of SRI.
Are markets as elastic as suggested?
While their evidence convinced Berk and van Binsbergen that the increased popularity of sustainable investment strategies was not having an impact on valuations, and thus a firm’s cost of capital, Xavier Gabaix and Ralph S.J. Koijen, authors of the April 2021 study, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” found that equity markets have become more inelastic over time, stating: “Investing $1 in the stock market increases the market’s aggregate value by about $5. We also show that we can trace back the time variation in the market’s volatility to flows and demand shocks of different investors. … This high sensitivity of prices to flows has large consequences: flows in the market affect market prices and expected returns in a quantitatively important way.” Their work helps explain the increased volatility of individual stocks.
Given the strong trend toward investors’ preferences for sustainable strategies, perhaps Berk and van Binsbergen’s estimates will prove to be wrong by a wide margin. If that is the case, then despite brown stocks having higher ex-ante returns, green stocks can outperform – with the outperformance driven by rising relative valuations favoring green stocks, creating capital gains in the short-term, though lowering future expected returns. If that turns out to be true, sustainable investors will have achieved their dual mandate of higher returns and a positive impact on society!
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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