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New Research on ESG Outperformance

How and when does ESG outperform other investment styles?

New research demonstrates that while ESG investing has performed well over the last decade, continued outperformance will depend on a heightened concern for environmental issues. Several recent studies have found strong evidence that the incorporation of environmental, social and governance (ESG) concerns into investment analysis has led to better-risk adjusted returns for investors. Incorporating ESG information not only helps investors avoid risks associated with poor corporate behaviour, it also seems to increase the quality of investments, particularly during periods of market turbulence.

For example, Avramov et. al. (October 2021) found that between January 2010 and December 2018, a mildly green large cap portfolio outperformed a brown large cap portfolio by about two percentage points per year, after controlling for expected return patterns and volatility.

“At present, investors may want to participate in the performance of green stocks, which we believe have positive long-run future growth potential. This stems from the fact that while green assets, such as wind power plants and electric cars, face a number of regulatory and market frictions, technological advancements and high durability of green products mean green assets can have higher realized returns while agents’ tastes shift unexpectedly in the green direction.”

“However,” they added, “while green assets are desirable, so too are brown assets, such as oil and gas, which are subject to an acquisition of adjacent assets by energy companies. This can cause a shift in tastes away from green assets, which would lead to a reduction in stock prices.”

The 2021 Yale study, “Climate Change Concerns and the Performance of Green Versus Brown” Stocks” examines the association between climate change risk, measured by climate change news, and stock performance. The researchers estimate that 1% (-1%) in relative stock price performance can be attributed to climate change, net of debt.

The stock market is notoriously risky, so it's important to be able to invest wisely. The value of green investments is growing, but investors might not be aware of it.

When researchers looked at the top green stocks, they found that their performance vastly exceeded the performance of the other stocks.

- The outperformance of green stock cannot be explained by factors that are prominent in the asset pricing literature (e.g. the value premium or the momentum premium). To explain their finding, the authors instead observed a surprising increase in the concern over climate change, which resulted in an increase in the corresponding green stocks. The measure of climate concern nearly doubled over the last decade and only green companies (i.e. high CO2 emitters) outperformed.

-    Green stocks explained all of the momentum premium over the period.

-    Strengthened climate concerns would not have outperformed brown stocks if not for climate shock shocks.

-    Investing into the brown stocks suggests that investor sentiment towards climate change grew, slowing market activity around climate change questions such as carbon tax, pollution and environmentally friendly claims.

-    Industry-level greenness accounted for the superior performance of green stocks.

-    If climate change concerns increase, both the demand for greener products and companies will go up. This will push up the prices of stocks in eco-friendly companies relative to those who aren’t.

-    The HML factor has recently been outperforming , outgaining its both factor-mimicking portfolios and a large-cap growth benchmark. This has resulted in a small positive alpha, which has faded in value from 34 basis points per month ( it with a green factor, and 36 basis points per month) to just 15 basis points per month. To help maintain its popularity, the Skeptical Advisor could have provided some support for a contrarian argument. According to the Global Bullion Market Association, the gold-silver price ratio—the proportion between the two metals—has moved from about 71 in 2000 to 86 in February 2018. It peaked in September 2011 at 89.

-    Green stocks’ performance explained all of the momentum premium over the period. Out of all the fixed-income securities issued in Germany last year, the green ones had the worst return and were the worst performing relative to their peers. Despite their inferior performance, green bonds outperformed their lower-yielding, non-green twins (non-green bonds issued by the government) because the yield spread between the two groups of fixed- income securities widened.

If all investors knew that greener products were going to be in higher demand in the future, and that green products would be more affordable than conventional goods, then investors would expect green products to perform better than the conventional stocks. Indeed, that was the case in the late 1990s. But such a rally was a prime example of a speculative bubble where investors expected prices of products to increase because investors expected them to be in demand, which almost always leads to overvaluation. It is possible that fresher memories of unsustainable practices are still influencing investors who then extrapolate those practices into the future, and believe that the increased demand for sustainable products means that sustainable products will perform better than the conventional stocks.

Ryan Beasly

Machine Learning Engineer

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