Why ESG Funds Have Outperformed – ValueWalk Premium

Why ESG Funds Have Outperformed

The rising popularity of ESG investing has driven asset flows to green stocks. But new research confirms that the resulting higher valuations forebode lower returns for climate-conscious investors.

Many consider climate change to be one of the biggest challenges of our time. Investors are expressing their concerns by dramatically increasing investments in companies with good ESG scores. According to the 2020 Report on U.S. Sustainable and Impact Investing Trends, ESG investing now accounts for more than one-third of total assets under management in the U.S., or about $17 trillion, a 42% increase since 20181.

Q1 2022 hedge fund letters, conferences and more

David Ardia, Keven Bluteau, Kris Boudt and Koen Inghelbrecht contribute to the sustainable investing literature with their February 2021 study, “Climate Change Concerns and the Performance of Green Versus Brown Stocks,” in which they tested the hypothesis of Lubos Pastor, Robert Stambaugh and Lucien Taylor, authors of the August 2020 paper, “Sustainable Investing in Equilibrium,” that because of increased cash flows, green firms outperform brown firms when concerns about climate change increase unexpectedly.

Their database consisted of S&P 500 companies and covered the period January 2010 to June 2018. To capture unexpected increases in climate change concerns, they constructed a media climate change concerns (MCCC) index using news about climate change published by eight major U.S. newspapers. Their index measured the level of negativity as well as the level of risk and uncertainty discussed in each article. To quantify a firm’s greenness, they relied on the ASSET4/Refinitiv carbon-dioxide-equivalent (CO2-equivalent) greenhouse gas (GHG) emissions data scaled by firms’ revenue. The variable measures a firm’s emissions intensity, i.e., the number of tons of CO2-equivalent GHG emissions necessary for a firm to generate $1 million in revenue. Firms below the 25th percentile are defined as green, and those above the 75th percentile are defined as brown.

Following is a summary of their findings:

  • Investors’ strategies regarding climate change tended toward a screening of brown firms, with reallocation to both green and neutral firms.
  • When concerns about climate change increased unexpectedly, green stock prices increased, while brown stock prices decreased. This relationship was stronger, in absolute terms, for the brown portfolio than for the green portfolio—when there was an unexpected increase in climate change concerns, investors tended to penalize brown firms more than they reward green firms.
  • The lower (higher) the emissions intensity, the more positive (negative) the exposure to unexpected increases in climate change concerns.
  • Climate change concerns affected returns both through investors updating their expectations about firms’ future cash flows and through changes in investors’ preferences for sustainability.
  • There was no significant difference between firms that disclosed their emissions and those that did not.
  • Their analysis identified five themes related to climate change that have had a significant relationship with green versus brown firms’ stock performance: (1) financial and regulation, (2) agreements and summits, (3) societal impact, (4) research and (5) disasters. The financial and regulation theme primarily affects the cash flow channel; the research and disasters themes affected the investor tastes channel; and the agreements and summits and societal impact themes may have affected both channels.
  • Green firms invested more, and brown firms invested less. The explanation is that green firms’ capital costs were lower than brown firms, and thus they had more investment opportunities.

Their findings led Ardia, Bluteau, Boudt and Inghelbrecht to conclude that they empirically verified the prediction of Pastor, Stambaugh and Taylor that green firms outperformed brown firms when climate change concerns increased unexpectedly. Their findings explain the recent outperformance of green versus brown stocks despite green stocks having lower ex-ante (expected) returns.

Read the full article here by , Advisor Perspectives.

Saved Articles