Will “Green” Stocks Continue To Outperform? – ValueWalk Premium
Stock Market Carvana

Will “Green” Stocks Continue To Outperform?

Economic theory says that “green” stocks – those of companies with a low carbon footprint – should underperform “brown” ones. But in recent years that has not been the case, and new research explains how cash flows to sustainable strategies have driven short-term outperformance.

Q4 2021 hedge fund letters, conferences and more

In the face of accelerating climate change, investors are making capital allocations seeking to decarbonize portfolios by reducing the carbon intensity of their holdings. Alexander Cheema-Fox, Bridget Realmuto LaPerla, George Serafeim, David Turkington and Hui (Stacie) Wang contribute to the sustainable-investing literature with their study, “Decarbonization Factors,” published in the fall 2021 issue of The Journal of Impact and ESG Investing. They examined whether institutional flows to decarbonization strategies affect returns as investors incorporate information about climate change into their investment processes.

Their data sample spanned the period June 30, 2009-December 31, 2018, for the United States and Europe. They constructed decarbonization factors that were industry neutral and went long low-carbon-intensity and short high-carbon-intensity sectors, industries or companies with a market cap of at least $2 billion. They classified sectors, industries or companies into high or low carbon emissions by the sum of scope 1 and scope 2 carbon emissions over sales. This metric is known as carbon intensity and reflects how carbon efficiently one dollar of revenue is generated. They considered six portfolio formation strategies including rotations across industries and sectors and across companies (best in class). Portfolios were re-formed annually.

Following is a summary of their findings:

  • Different strategies produce carbon emissions that vary greatly.
  • Strategies that lowered carbon emissions more aggressively performed better (an alpha of about 2%, especially in Europe) – after controlling for traditional factors (market, size, value, momentum, investment and profitability) and the oil return (the return from crude oil on the futures market). Decarbonization factors that achieve greater carbon reduction also deliver greater alphas.
  • Decarbonization factor returns are associated with contemporaneous institutional flows into the factors – buying decarbonization factors when coincident flows are positive while selling when they are negative yields significant alphas – between 1.5% and 4.4% in the United States and 2.5% and 8.5% in Europe over the sample period.
  • Combining decarbonization factors without accounting for flows hardly improved portfolio performance in almost all cases.
  • Decarbonization strategies had better risk-adjusted performance since 2012 compared to 2009-2011.
  • The results were more pronounced in Europe relative to the U.S. This is likely due to Europe having responded more aggressively to climate change by instituting a pricing system for carbon emissions (the European Union Emissions Trading System), which provides more systematic market incentives for businesses to lower their carbon emissions because of stricter carbon regulations and consumers who are generally more sensitive to climate change-related choices.
  • The decarbonization factors exhibited strong negative correlation with the investment factor and the profitability factor.

Their results led the authors to conclude: “Institutional investor flows contain information about anticipated fundamentals related to climate change developments.” Their findings are consistent with the economic theory that “brown” stocks have higher expected returns, though “green” stocks can outperform in the short term due to cash flows.

Read the full article here by Advisor Perspectives

Saved Articles