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.
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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.
- Expected green asset returns were negatively associated with time-varying convenience yields, while exposures to ESG preference shocks led to positive green premiums – a challenge to the negative ESG-expected return relationship (there should be an ex-ante brown, or “sin,” premium).
- Augmenting these conflicting forces with positive contemporaneous effects of preference shocks on realized returns, the green-minus-brown (GMB) portfolio delivered large positive payoffs for reasonably long horizons.
- Nonpecuniary benefits from ESG investing accounted for a nontrivial and increasing fraction of total consumption. Over the full sample, the estimated ESG benefits amounted to 0.74% of total consumption, significant at conventional levels. However, that figure was much higher today (5.0%) due to advancing levels of ESG demand.
- Over the full sample period, the model-implied average expected excess return of the green portfolio was 7.4%, while it was higher at 8.3% for the brown portfolio. The GMB portfolio had a negative and statistically significant average expected return of -0.9% per annum. Considering the combined effect of the conditional expected return and the unexpected return due to demand shocks, the GMB portfolio average return was a negligible -0.1%. In other words, while the realized total return of the GMB portfolio was about zero, the expected return was -28%.
- Over the final three years of the sample (2018-2020), the green portfolio had average excess returns of 14.2% versus just 7.0% for the brown portfolio, evidence of the dynamic nature of the convenience yield.
- Considering linear growth, the convenience yield is expected to increase from -6 basis points per month in 2020 to -21 basis points per month in 2030, with significant implications for realized returns.
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.”
Read the full article here by Larry Swedroe, Advisor Perspectives.
