ESG loyalty will be tested as performance starts to lag

The good news for ESG investors is that the waves of bad environmental news over the past several years have been the primary contributor to recent investment performance.

That’s also the bad news because, by simple economic logic, the only way ESG strategies can continue to outperform the broader market is through the existence of more and greater environmental catastrophes.

This is the fundamental premise of an academic study by a team of big thinkers from the University of Chicago Booth School of Business and the Wharton School of the University of Pennsylvania.

The paper has only been out since June and the authors are anticipating the standard exchange of academic criticism, but if the reasoning holds water, it could create a unique set of challenges for financial advisers trying to help clients invest their values while potentially sacrificing investment performance.

In some ways, this harkens to the early days of sustainable investing when certain companies were screened out, even if that meant diminished investment performance.

The current version of the story underscores the warning that past performance is not necessarily indicative of future returns, and when it comes to ESG strategies, investors will need to be comfortable with the idea that the reward is knowing you’re helping to make the world a better place.

“ESG investors should not expect that high recent performance to continue,” said Lucian Taylor, Wharton finance professor, and one of the authors of the report, Dissecting Green Returns.

“The last several years were special years in an unexpected way,” he added. “When people become more concerned about climate change that makes green stocks outperform.”

As explained by Taylor, the green factor, or “greenium,” starts with negative news about the environment, which leads to increased investor appetite for ESG investments, which results in stronger performance for ESG strategies.

According to the report, the greenium produced a cumulative investment performance spread between November 2012 and December 2020 of 35% over non-ESG investments.

The ESG outperformance was particularly evident in 2020 with examples like Invesco Solar ETF (TAN) gaining 234%, FirstTrust Nasdaq Clean Energy ETF (QCLN) gaining 184%, and iShares Global Clean Energy ETF (ICLN) gaining 141%.

By comparison, the S&P 500 Index gained 16.3% in 2020.

Through Sept. 9 of this year, TAN is down 18.9%, QCLN is down 7.1%, and ICLN is down 19.6%.

The S&P is up 18.7% over the same period this year.

The research report separated “green” and “brown” companies based on the global ESG scores calculated by MSCI. The researchers then studied the impact of climate-related news reports on the stock price performance of those companies.

“Where we are today, green stocks are fairly valued, but they have high prices because ESG investors like holding them, and because they have high prices today, they have low expected returns in the future,” Taylor said.

To test the theory that negative climate news drove up green stocks, the researchers “set the climate shocks to zero” and found that green stocks lagged their less-environmentally friendly counterparts.

“When we zero out flows into ESG funds and remove the climate shocks, we find green stocks would have underperformed,” Taylor said. “That’s what leads us to conclude this past great outperformance should not be expected to continue and tells us the future of green assets might be quite bad relative to the past eight years.”

While it might seem logical that the same kind of negative climate news that drove recent ESG investment performance could continue to do so, Taylor argues that green stocks are already priced high based on past climate shocks and that the unique loyalty of many ESG investors will keep those prices high.

“People really like holding these green stocks today and that means their prices are high today,” he said. “That also means their expected future returns should be low.”

While this might not sound like great news to any investor or financial adviser who jumped on the ESG bandwagon for the recent performance, it should be good news for ESG purists.

“One way you can make the world a better place is by reducing the cost of capital for green companies and increasing the cost of capital for environmentally unfriendly companies,” Taylor said. “If you’re an ESG investor, you want green stocks to have lower expected returns because the expected return is the cost of capital.”

So, while green stocks rode the wave of bad climate news and potentially drew some converts to the ESG side of the house, the real test will be how investors and advisers start to balance doing good for the planet against doing less good for the portfolio.