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Integrate Your Personal Values and Financial Goals with ESG Investing

The following is an adapted excerpt from the conclusion of the forthcoming book “Your Essential Guide to Sustainable Investing” by Sam Adams and Larry Swedroe. Sam and Larry summarize some of the topics they cover in the book and present some key takeaways.

The financial services industry has responded to demands for sustainable investment strategies with a dizzying array of product launches, however fund sponsors are not using consistent terms to describe their products, using terms like ESG and SRI interchangeably, or calling the whole field “impact investing.” Others use terms such as “values-based investing,” “mission-driven investing,” “ethical investing,” or even just “responsible investing.”

The lack of a common nomenclature makes it difficult for investors to understand what is available, what their purpose is, and what their performance might be. The key takeaway is that investors should first clearly define their own values and objectives. Having done so, they should perform a thorough due diligence on any fund or manager so that they can be sure the strategy employed (such as the type of screens—negative, positive, best-in-class, norms-based, etc.) aligns with their values.

Why Do Investors Want to Invest Sustainably?

Given their various motivations, sustainable investors may earn three types of “returns”: financial, societal (improved outcomes for both people and the planet), and personal (emotional benefits). The key takeaway is that investors should make sure the investment strategies they employ align with not only their financial objectives but also their societal goals and personal values.

A historical review of the evolution of ESG investing shows that early ESG investors were faced with real challenges, as they lacked the critical ingredient needed to invest in a more responsible manner—data and a consistent set of metrics to compare companies. Fortunately, ratings organizations were formed to address this problem. Unfortunately, there is no consistency in how the ratings are determined, in terms of the categories measured, metrics used to measure those categories or their weighting schemes. The result is that for the same company, there can be a wide dispersion of scores among the various providers. Thus, one key takeaway is that instead of attempting to compare and contrast ratings and rankings of different ratings agencies, investors should determine the ESG constructs that are material to their own investment strategies and then match them with an ESG rating or ranking product that closely resembles those constructs.

Is There a Price for Sustainable Investing?

Economic theory posits that if a large enough proportion of investors choose to favor companies with high sustainability ratings and avoid those with low sustainability ratings, the favored company’s share prices will be elevated and the “sin” stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium on the screened assets. The result is that the favored companies will have a lower cost of capital because they will trade at a higher P/E ratio. The flip side of a lower cost of capital is a lower expected return to shareholders. Conversely, the “sin” companies will have a higher cost of capital because they will trade at a lower P/E ratio. The flip side of a company’s higher cost of capital is a higher expected return to shareholders. The hypothesis is that the higher expected returns (above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the “cost” of expressing their values.

There is also a risk-based hypothesis for the “sin” premium. It is logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. Their stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption, and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium.

Conflicting Forces

Investor preferences can lead to different short- and long-term impacts on asset prices and returns. For example, if investor demand increases for firms with high sustainable investing scores, that could lead to short-term capital gains for their stocks— realized returns rise temporarily. However, the long-term effect is that the higher valuations reduce expected long-term returns. The result can be an increase in “green” asset returns even though “brown” assets earn higher expected returns. In other words, there can be an ambiguous relationship between sustainable risks and returns in the short term. And these conflicting forces, along with the difficulties created by the aforementioned dispersion in sustainability ratings by the various providers, can create challenges for investors in interpreting the findings from academic papers.

Despite these difficulties, the literature does provide us with some key takeaways. First, sustainable investment strategies that do not take into account factor exposures should expect lower returns. However, sustainable strategies also reduce risk. Thus, there may not be a sacrifice in risk-adjusted returns. Second, in the short-term, the increased demand from sustainable investors might even be sufficient to offset the ex-ante lower expected return as valuations of green stocks relative to brown stocks increase. However, once a new equilibrium is reached, lower returns, along with lower risk, should be the expectation. This is important, as the evidence from studies such as “Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows” has found that mutual fund investors, both individual and institutional, collectively treat sustainability as a positive fund attribute, allocating more money to funds ranked five Morningstar globes and less money to funds ranked one globe.1 Third, the lower expected returns can be offset by increasing exposure to factors with higher expected returns (such as size, value, momentum, and profitability). Fourth, markets are becoming more efficient, quickly incorporating information as to sustainable risks into prices. Fifth, if you are going to make sustainable investing a core of your investment philosophy, thorough due diligence is required before committing assets. That due diligence should not only include the screening methodologies but also a careful examination of factor loadings, industry concentrations, and expenses. And finally, investors are best served by assessing investment implications of sustainable strategies on a fund-by-fund basis.

It is also important to note that in its 2018 research report, “Big Data Shakes Up ESG Investing,” Deutsche Bank estimated that the share of sustainable investment assets may increase from about 50% in 2020 to about 95% in 2035.2 That means we may not reach a “new equilibrium” for quite some time. Supporting this view is that the authors of the 2020 study “ES Risks and Shareholder Voice” found that a majority of ESG proposals have not been supported by shareholders, and in particular by institutional investors, suggesting that today’s investors care predominantly about performance. With a shift toward more concerns about sustainability, this could change in the near future.The result could be that, until that new equilibrium is reached, sustainable investors could “have their cake and eat it too,” as the benefits from increased cash flows could drive up valuations of “green” companies relative to “brown” companies. If that were the case, sustainable investors might realize higher returns while experiencing less risk. How long this trend lasts will depend on the speed with which investors adopt sustainable strategies.

The Impact of Sustainable Investing

In reviewing the evidence on how sustainable investors are impacting companies and their employees, we learn academic research has found that companies that adhere to positive environmental, social, and governance principles have lower costs of capital, higher valuations, are less vulnerable to systemic risks, and are more profitable. Thus, by expressing their values through their investments, sustainable investors are positively impacting companies as they seek the advantages of lower costs of capital and the benefits of a more satisfied and motivated workforce.

We also looked at whether ESG investors provide societal benefits through their impact on asset prices. By pushing green asset prices up (lowering the cost of capital) and brown ones down (raising the cost of capital), investors’ tastes for green holdings induce more investment by green firms and less investment by brown firms. The more investors care about ESG, the greater the positive environmental impact as emissions are reduced, and the greater the social impact as well.

The bottom line is that sustainable investing is no longer a niche movement. We are witnessing a convergence between corporate sustainability and sustainable investing that is a major force driving market change as investors increasingly focus their attention on sustainable factors.

  1. Samuel M. Hartzmark and Abigail Sussman, “Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows,” The Journal of Finance (August 2019).
  2. Deutsche Bank, “Big Data Shakes Up ESG Investing,” 2018.
  3. Yazhou He, Bige Kahraman, and Michelle Lowry, “ES Risks and Shareholder Voice,” September 2020.

Reprinted with permission from Harriman House.

By: LARRY SWEDROE
Chief Research Officer

Sources: © 2021 Buckingham Strategic Partners®