When the COVID-19 pandemic prompted global stock markets to plunge in March 2020, Chicago Booth’s Lubos Pastor and Booth PhD student M. Blair Vorsatz set out to see if active managers outperformed stock indexes in choppy markets. But they stumbled on an unexpected insight.
Most active funds underperformed passive benchmarks during the crisis, they find, but what surprised them is funds that had high sustainability ratings had higher benchmark-adjusted returns. Morningstar, the investment research company, rates a fund’s sustainability according to environmental, social, and governance (ESG) factors, and it assigns each fund a globe rating—with funds that earn five globes being the most sustainable. Five-globe funds outperformed four-globe ones, which in turn outperformed three-globe ones, and so on, Pastor and Vorsatz observe. “This result is driven largely by environmental sustainability,” the researchers write, emphasizing the E in ESG.
And fund flows matched performance. Between February 20 (the day after the stock market peaked) and April 30 (after the market had largely recovered), active funds recorded fund outflows of 1.3 percent of assets under management as nervous investors pulled out. But the net flows for five-globe funds were around zero. Those with the lowest Morningstar sustainability score had net outflows of almost $7 billion (2.7 percent of assets), and those with the highest sustainability rating received net inflows of $460 million (0.1 percent of assets). Similarly, funds that apply exclusion criteria on the basis of ESG factors in their investment process, by screening out certain companies or industries, such as oil producers, also generated net inflows, of $1 billion (1.2 percent of assets).
“Our finding that investors remain focused on sustainability during this major crisis suggests they view sustainability as a necessity rather than a luxury good,” write Pastor and Vorsatz.
Sustainability is a new twist on an old theme in investing. Socially responsible investing has been around in some form for decades, if not millennia, explains Jon Lukomnik, senior fellow at High Meadows Institute, and author of a forthcoming book examining modern portfolio theory and systemic risk. Muslims have long created investments to comply with sharia, and some churches have similarly preferred investment vehicles that screen out companies in alcohol, tobacco, and gambling.
The concept of sustainability has gone mainstream more recently, often associated with a subset of it, which integrates ESG into investing decisions. Funds across the globe have begun including ESG factors in the security-selection process. Several companies, including Morningstar and MSCI, score stocks and assets according to ESG, and BlackRock, the world’s largest asset manager, is integrating ESG into its risk analyses and is working to make more sustainable options available to clients.
As the E in ESG, green investing is not without controversy, in part due to a lack of clarity surrounding what companies do or should report. But like climate change, green investing may be at a tipping point, and research suggests their trajectories are closely related.
Investors prefer sustainability
In 2016, Morningstar launched sustainability ratings for 20,000 funds in its database—an action that took sustainability from something that was opaque for investors “to being clearly displayed and touted by one of the leading financial research websites,” observe Chicago Booth’s Samuel Hartzmark and Abigail Sussman, who in a 2019 paper analyzed the ratings’ effect.
Simply calling attention to sustainability prompted changes in how investors allocated their assets. Money flowed out of mutual funds with the lowest rating and into those with the highest rating. The researchers estimate that in the 11 months after the ratings were issued, between $12 billion and $15 billion flowed out of funds that received just one globe out of five, while between $24 billion and $32 billion flowed into funds awarded five globes.
In a follow-up experiment, Hartzmark and Sussman teased apart investors’ reasoning and find that the investment decisions were motivated both by performance expectations and what appeared to be altruistic and environmental motives. Investors tend to believe that more-sustainable companies will outperform the market—and they place a high value on social responsibility when investing.
Sustainable funds were a decent place to be when COVID-19 hit the markets
After stocks began to plunge in February 2020, funds with higher sustainability ratings outperformed those with lower ratings.
Yet the evidence is mixed on whether sustainable investments pay off. Several papers have made the case that investments made with ESG in mind underperform. Perhaps the best-known example is a 2009 paper by Columbia’s Harrison Hong and Imperial College London’s Marcin Kacperczyk, who looked at “sin stocks,” those of companies in the alcohol, tobacco, and gaming industries. Sin stocks create negative externalities, costs that are borne by society, and some investors avoid these companies on moral grounds or as a result of the higher legal risk. Hong and Kacperczyk find that in doing so, investors depress the prices of sin stocks, which less-constrained investors then pick up on the cheap. Thus sin stocks outperform comparable stocks by about 0.3 percentage points per month, or around 3.6 percent per year.
But other research arrives at a different conclusion, arguing that in at least some time periods, investments that are more socially responsible outperform. For example, Illinois State University’s Abhishek Varma and University of Alaska’s John R. Nofsinger studied domestic equity mutual funds between 2000 and 2011 and find that socially responsible mutual funds tend to outperform during market crises. They also find that such funds underperform during noncrisis periods and that the performance of socially responsible funds and conventional funds is roughly the same over time.
Pastor and Vorsatz analyzed a shorter time frame but more funds—over 3,600 of them, representing nearly $5 trillion in net assets—in arriving at their conclusion that funds with higher sustainability ratings posted higher returns in the COVID-19 crisis period.
When green investments can outperform
Theory may help explain these seemingly contrasting results. Seeing little in the academic finance literature on this front, particularly when it comes to investments that are specifically environmentally sustainable, Pastor and University of Pennsylvania’s Lucian A. Taylor and Robert F. Stambaugh have developed a model to explain what going green could mean for investors and society. The model formalizes Hong and Kacperczyk’s observation that sustainable assets have lower expected returns. In the model, if a group of investors wants to hold green assets, they bid up the prices for those stocks. The risk-adjusted returns will be lower for those more-expensive, green stocks and higher for the less-expensive, nongreen ones.
However, the researchers also find that investors who prefer green assets are prepared to earn lower financial returns. The model explains that, in order to get their desired portfolio, they earn lower financial returns than non-ESG investors. But they are willing to sacrifice more than they actually do, and thus earn what the researchers term an “investor surplus.” In addition, the nonfinancial benefits they earn from green investing more than compensate for the lower financial returns.
Even investors focused only on profits have some reason to embrace green assets, the model predicts. The researchers consider climate risk and news associated with it. When a giant iceberg splits from an Antarctic ice shelf, it is unlikely to have a direct or immediate impact on society or the stock market. However, as a dramatic example of the effects of climate change, it can attract attention and make the news. That can in turn compel consumers to buy green products, push governments to pass the kind of environmental legislation that the researchers expect to benefit green companies and hurt brown ones (those that generate negative externalities), and prompt regulators to take action. Politicians, notes Pastor, “always juggle multiple agendas. For the environment to rise to the top, something needs to happen.”
Focused on sustainability
Amid the COVID-19 crisis, investors were more likely to stick with funds with higher sustainability ratings and drop those with lower ratings.
So whenever there’s bad climate news, green stocks benefit, and such stocks effectively become a hedge against headlines about climate change. Even if investors think global warming is a hoax, it represents a risk, and they will want to hold stocks that hedge market-moving bad news.
In some cases, the model suggests, green stocks will outperform brown stocks, which could explain Pastor and Vorsatz’s observations during the COVID-19 crisis. If consumers decide, unexpectedly, that there is value in going green—whether that means buying electric cars or seeking out plastic-free products—green stocks can outperform in the short run, even though they generally have lower risk-adjusted returns. Thus, green assets can outperform brown ones in periods when investors’ tastes are becoming greener. This of course assumes that some investors will continue to prefer polluters and other brown stocks. If all investors were to move green, the entire market would adjust, and green would become the new benchmark.
Good for society too
A move to ESG investments can also be good for society, write Pastor, Taylor, and Stambaugh. This may seem obvious, until you look at their underlying reasoning.
Milton Friedman, the late University of Chicago professor and 1976 Nobel laureate, famously argued in a 1970 New York Times article that companies should focus on profits and let shareholders direct their portion to social programs if they choose to. Managers have a responsibility to shareholders—and only shareholders, Friedman argued. “That responsibility is to conduct the business in accordance with their desires, which will generally be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom,” he wrote.
Harvard’s Oliver Hart and Chicago Booth’s Luigi Zingales have since argued that company managers should instead maximize shareholder welfare, which they see as broader than shareholder value. Shareholders care about more than money, Hart and Zingales write—they also have ethical and social concerns. While it might be possible in some cases for a company to separate its moneymaking from its do-gooding, in other cases it’s more complicated. How do you untangle an issue such as Walmart selling high-capacity ammunition magazines if some of its shareholders favor gun control, for example? (For more, read the essay “It’s Time to Rethink Milton Friedman’s ‘Shareholder Value’ Argument.”)
Despite the unanswered questions, investors seem to be piling on board—particularly investors from outside the United States, research suggests.
Pastor, Taylor, and Stambaugh stick with the Friedman way of looking at the world. In their model, managers couldn't care less about ESG or being green and simply focus on maximizing market value. But ESG investing has a positive social impact nevertheless. If outside investors care about being socially responsible, managers may follow suit purely to increase the company's market value. And when investors have a taste for green stocks, the companies they buy develop a lower cost of capital. Managers end up gravitating to ESG, enticed by higher stock prices and that lower cost of capital.
The net effects are good for society, the researchers conclude. When there are more investors who care about ESG, this boosts the price of greener stocks, which in turn induces ESG companies to invest more in their operations. The result is greater positive social impact, whether in the form of cleaner rivers, happier employees, or healthier markets.
Who decides what’s green?
This theory on green investing is simple and breaks new ground. That’s because while green investing may be established and close to mainstream, academic research on the subject, and on ESG more generally, is only just getting going.
Perhaps because of that lag, ESG is a woolly term. In the investment market, it’s not at all clear what it actually means. For some investors, ESG is evolving into just another investing style, a way to find an edge by including material factors not yet priced by the market, such as employee satisfaction, that can deliver outperformance. Others focus on ESG factors that highlight systemic, societal risks, such as environmental degradation, which have an impact on companies across an investor’s portfolio. And it gets complicated: a company could be a great employer for working mothers but also a large emitter of greenhouse gases. A corporation might be favored by environmentalists but attacked for poor labor practices.
Although ESG ratings make more information salient for investors, ESG investing risks becoming diluted, says Kimberly Gladman, senior associate at ValueEdge Advisers and a lecturer at Boston University. “The number of people who claim they’re doing it now is vastly expanded,” she says. “But the definition is so weakened that it is very, very far from the original intent.”
This concern is one reason many researchers and investors, among others, have pushed to standardize key metrics of sustainability for different industries and develop a reporting framework. Chicago Booth’s Hans B. Christensen and Christian Leuz and University of Pennsylvania’s Luzi Hail have collected various arguments and compiled them in a report and an accompanying working paper. (For more, read “Should Sustainability Disclosures be Standardized?”)
Despite the unanswered questions, investors seem to be piling on board—particularly investors from outside the United States, research suggests. Booth’s Ralph S. J. Koijen, NYU’s Robert J. Richmond, and Princeton’s Motohiro Yogo find that demand for green companies in the US stock market is coming at least in part from foreign investors, including sovereign wealth funds. “Larger, passive, and foreign investors have a stronger demand for greener firms,” they write, noting that State Street, PRIMECAP, and Vanguard are the most influential among US investors, and the Norwegian sovereign wealth fund is most so among foreign investors.
Under the Trump administration, the US relaxed environmental regulations, but that trend may reverse under President Joe Biden. And at least in theory, stricter environmental rules could benefit green stocks—and their investors.—With Brett Nelson
- Hans B. Christensen, Luzi Hail, and Christian Leuz, “Adoption of CSR and Sustainability Reporting Standards: Economic Analysis and Review,” Working paper, July 2019.
- “Economic Analysis of Widespread Adoption of CSR and Sustainability Reporting Standards,” Working paper, January 2019.
- Oliver Hart and Luigi Zingales, “Companies Should Maximize Shareholder Welfare, Not Market Value,” Journal of Law, Finance, and Accounting, August 2017.
- Samuel Hartzmark and Abigail Sussman, “Do Investors Value Sustainability? A Natural Experiment Explaining Ranking and Fund Flows,” Journal of Finance, August 2019.
- Harrison Hong and Marcin Kacperczyk, “The Price of Sin: The Effects of Social Norms on Markets,” Journal of Financial Economics, April 2009.
- Ralph S. J. Koijen, Robert J. Richmond, and Motohiro Yogo, “Which Investors Matter for Equity Valuations and Expected Returns?” Working paper, December 2020.
- Lubos Pastor, Lucian A. Taylor, and Robert F. Stambaugh, “Sustainable Investing in Equilibrium,” Journal of Financial Economics, forthcoming.
- Lubos Pastor and M. Blair Vorsatz, “Mutual Fund Performance and Flows during the COVID-19 Crisis,” Review of Asset Pricing Studies, December 2020.
- Abhishek Varma and John R. Nofsinger, “Socially Responsible Funds and Market Crises,” Journal of Banking and Finance, November 2014.
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