New research shows that positive returns to ESG portfolios from 2018-2020 were attributed to increased demand for “green“ stocks, raising the question of whether that outperformance will be sustained.
The trend toward sustainable investing has seen explosive growth in recent years. According to Morningstar, in 2020 sustainable funds pulled $370 billion in new money, more than twice the amount in 2019, and flows for the first half of 2021 were $320 billion. As of June 2021, the combined assets managed by sustainable funds reached $2.25 trillion, up from about $700 billion at the end of 20181. The goal of sustainable investors is to generate tangible social and environmental benefits in addition to achieving financial returns. The incremental benefit is attributed to the role sustainable assets play in reshaping global standards – when investors are “brown” averse and the market is “green,” the effective (ESG-adjusted) return on wealth is perceived higher than justthe financial return.
Doron Avramov, Abraham Lioui, Yang Liu and Andrea Tarelli contribute to the sustainable investment literature with their October 2021 study, “Dynamic ESG Equilibrium,” in which they developed and applied an equilibrium model that accounts for ESG demand and supply dynamics. They explained: “A dynamic model can naturally accommodate preference shocks for sustainable investing as well as supply shocks. Preference shocks reflect the unexpected component of the growing interest in sustainable investing over recent years.”
They collected ESG scores from three data vendors: MSCI KLD (available from 1991 to 2015), MSCI IVA (available from 2007 to 2019) and Refinitiv Asset4 (available from 2002 to 2019). They constructed brown, neutral and green portfolios, consisting of stocks with consensus ESG scores below the 30th, between the 30th and the 70th, and above the 70th percentile, respectively. Their sample period was 1992-2020. Following is a summary of their findings:
- In equilibrium, ESG preference shocks represented a novel risk source characterized by diminishing marginal utility and positive premium.
- With a high enough volatility of either ESG demand or ESG supply shocks, the positive effect on the ESG-expected return relation due to risk premium can dominate the negative effect due to investor preference.
- The market became substantially greener toward the second half of the sample.
- As the market got greener, a brown-averse agent became more sensitive to ESG demand and supply shocks and thus required a higher risk premium for holding the market. The required premium increased with the volatility of demand and supply shocks.
Their findings led the authors to conclude: “As the impact of unanticipated ESG demand shocks on realized returns can be sizable, this calls for caution when inferring future returns of ESG investments based on past realized returns. If anything, due to increasing convenience yield, future expected returns of green assets should diminish.” However, they also noted: “The cumulative return of the green-minus-brown portfolio is at 6% following a positive one standard deviation annual preference shock. The positive effect of realized returns vanishes only after about six years following the end of the shock. Hence, with the positive contemporaneous effects of preference shocks on realized returns, the green-minus-brown portfolio could deliver large positive average returns over reasonably long horizons.” In addition, they explained that “an unexpected increase in ESG demand may, for instance, reinforce demand for green products, thus boosting the profits of green firms on the account of brown firms.”
Investor takeaway
Studies such as the 2019 paper, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance,” have found that companies that adhered to positive environmental, social and governance principles had lower costs of capital, higher valuations, were less vulnerable to systemic risks and were more profitable. Thus, by expressing their values through their investments, sustainable investors are positively impacting companies as they seek the advantages of lower costs of capital, the benefits of a more satisfied and motivated workforce, and cater to customers who prefer corporations with a strong enough ESG reputation.
Further good news is that the increasing demand by investors for green investments is leading to an increase in the convenience yield, driving the valuations of green companies higher. The result is higher ex-post returns but lower future expected returns. However, while predicting the future is problematic, it seems clear that we are in the early stages of the trend to sustainable investing. As evidence, The Forum for Sustainable and Responsible Investing 2020 Trends Report showed that while one-half of all managed assets in Europe are currently managed with sustainable criteria, only one-third of all professionally managed money in the U.S. is. Thus, it is possible, if not likely, that we will see continued demand shocks that lead to positive premiums for green portfolios for quite some time. With that said, when positive preference shocks attenuate, we should expect green assets to deliver lower returns (the effect of a lower discount rate). However, that is not a certainty because an unexpected increase in ESG demand may reinforce demand for green products, thus boosting the profits of green firms on the account of brown firms (a cash flow effect).
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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1This narrative has been challenged.
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New research shows that positive returns to ESG portfolios from 2018-2020 were attributed to increased demand for “green“ stocks, raising the question of whether that outperformance will be sustained.
