- Individuals and large institutions alike
are allocating more of their dollars
to investment strategies that meet some level
of environmental, social and governance criteria.
This is commonly referred to as responsible, sustainable
or green investing.
I'll use sustainable to describe it in this video.
According to the 2018 global sustainable investment review,
as of the start of 2018,
more than 25% of US domiciled assets under management
were invested in sustainable strategies.
In Canada, it is just over 50% at 2.1 trillion
in Canadian dollar terms,
that's up 42% since 2016
BlackRock, one of the world's largest asset managers
recently committed to making sustainability
a key part of their investment process.
This growth in sustainable investing
is good news
to the extent that sustainable investing
leads to positive social impact,
but it also has some important implications
for expected investment outcomes.
I'm Ben Felix Portfolio Manager at PWL capital.
In this episode of common sense investing,
I'm going to tell you how you can align your investments
with your views and values.
But it's probably going to cost you.
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The two most common types
of sustainable investment strategies
are negative screening and ESG integration.
Negative screening
eliminates certain sectors,
companies or practices from a portfolio.
ESG integration is more of a re-weighting.
Instead of completely eliminating industries,
an integration strategy
will underweight companies with lower ESG scores
and increase the weight of companies
with higher ESG scores.
There are index funds that employ both of these strategies
often in combination with each other.
Having a sustainable portfolio sounds
like a really good idea
and it might feel even better than it sounds.
However, I think that you need to consider
two equally important factors
in deciding to implement a sustainable investment strategy.
The first factor is the impact on your expected returns.
And the second is the extent to which the investment
actually reflects your views and values.
These two considerations need to be assessed jointly.
If a sustainable portfolio
has slightly lower expected returns,
but is a perfect reflection of your views and values,
you may be willing to accept the trade off.
But accepting the lower expected returns
of a sustainable portfolio
that does not reflect your specific set of use and values,
might not be a trade-off
that most investors should consider.
Let's start with the impact
of socially responsible investing on unexpected returns.
The effect of ESG scores
on stock returns was examined in the 2019 paper
by Rocco Ciciretti, Ambrogio Dalo and Lehmertjan Dam.
They controlled for common risk factors
and looked at a global sample
of 5,972 firms for the period 2004 through 2018.
They found that companies with higher ESG scores
tended to deliver lower average returns
than companies with lower ESG scores.
They found a statistically significant negative premium
for the ESG characteristic
in a traditional Fama French five factor regression
a six factor regression, including momentum
and a seven factor regression, including an ESG risk factor.
They found that a one standard deviation decrease
in the ESG score is associated with a 0.13% increase
in monthly expected returns.
Put simply,
controlling for exposure
to known drivers of returns
companies with higher ESG scores
tend to do worse
than companies with lower ESG scores.
The authors considered two possible explanations
for this observation,
both grounded in economic theory
ESG characteristics reflect investor preferences
or ESG characteristics
are captured by some underlying ESG risk factor.
Based on the previously mentioned factor regressions,
they found it much more likely
that it is an investor preference
that drives a negative ESG premium.
Investors may be willing
to accept lower expected returns
simply because they do not want to invest
in certain types of firms.
This is not a risk premium
but an effective investor tastes.
That word tastes is important.
In their 2007 paper,
disagreements, tastes and asset prices, Eugene Fama,
and Ken French explained
that investors may hold an asset
partially as a consumption good,
regardless of its expected return profile.
If they have a taste for that asset.
If enough wealth is controlled
by investors with specific tastes
such as the case of sustainable investors,
the effect on prices could be meaningful.
Another way to think about this
is that investors with a taste for sustainable investments
require higher expected returns
to be convinced to invest in an unsustainable company.
This drives up the expected returns
of unsustainable companies.
They're also willing
to accept lower expected returns
to invest in sustainable companies.
This drives down the expected return
of sustainable companies.
In a 2019 study,
Olivia David Zerbib,
developed an asset pricing model
including premiums for ESG exclusion and investor tastes.
The premiums for exclusion
are related to the increased risk of stocks
that are neglected by sustainable investors.
The premium for investor tastes is related to the cost
of externalities
that sustainable investors internalize
to maximize their welfare
instead of the market value of their investments.
Using this model,
Zerbib analyze US stock data between 2000 and 2018.
He found an exclusion effect of 2.5% per year
and a taste effect of 1.5% per year.
These effects show the approximate magnitude
of under performance driven by respectively
a negative screen
and an integrated approach to a sustainable portfolio
over the time period examined.
As ESG preferences grows stronger,
the expectation is that these pricing effects
will become more pronounced
in a 2019 paper,
Lubos Pastor, Robert Stambaugh and Lucian Taylor
constructed a theoretical model to examine the implications
of ESG investing on expected returns.
They, again, found that firms
with higher ESG scores have lower expected returns
and those expected returns get lower
when risk aversion is low and ESG sensitivity is high.
They also found that the size of the ESG investment industry
increases as the dispersion of ESG preferences increases.
I know that was a lot to take in.
So think about it this way.
If everyone has the same ESG preferences,
the same willingness to invest in bad companies
if the expected return is high enough
and to invest in good companies,
despite a low expected return
then everyone will hold the market portfolio and be happy.
There will be no ESG investing industry
if everyone has the same preferences.
If there are two groups,
one group with no ESG preferences
and one group with strong ESG preferences,
then there is an ESG investing industry.
As the dispersion in ESG preferences grows,
the ESG investing industry gets bigger
and expected returns for sustainable portfolios
get lower.
Pastor, Stambaugh and Taylor,
also found that sustainable investing
leads to positive social impact
by encouraging sustainable firms
to invest more
while discouraging unsustainable firms
from investing due to the effects of investor preferences
on their cost of capital.
Let's recap.
Yes, you can encourage change in the world
by investing in companies that meet ESG criteria,
but as long as there is dispersion in ESG preferences,
you are doing so at the expense of lower expected returns.
This joint effect must be true.
If sustainable investing works the way
that it is supposed to,
by putting pressure on unsustainable companies,
then the firms excluded
from sustainable portfolios
must have higher expected returns,
meaning sustainable investors
must have lower expected returns
than the preference free market.
I think that we have established
that investors should expect lower risk adjusted returns
from a sustainable portfolio.
A portfolio with a negative screen
that entirely eliminates industries
will tend to be more
impactful to expect the returns
than a portfolio with an integration approach
that re-weights companies
based on their ESG score.
In either case,
lower expected returns are a consideration
for investors with above average ESG preferences
reflected in their portfolio.
Lower expected returns are not the only cost
that's sustainable investors endure,
by definition a sustainable portfolio,
must be less diversified than the market.
A reduction in diversification
reduces the reliability of the investment outcome.
If companies with high ESG scores
had higher expected returns,
the increased concentration and decreased reliability
could be viewed as a reasonable trade-off.
But companies with higher ESG scores
have lower expected returns.
We are getting a less reliable portfolio
with a lower expected return,
not an optimal trade-off.
We also have to consider fees,
a globally diversified portfolio of Canadian Listed iShares
ESG ETFs comes with a cost of around 0.28% per year.
While a similar iShare the ETF portfolio
with no ESG consideration would cost 0.12% per year,
lower expected returns, less diversification
and higher fees are the costs of a sustainable portfolio.
These costs exist on a continuum.
The more sustainable that we want to get
the higher the costs tend to get.
If we start on one end of the spectrum
we might have XIC,
the iShares core S&P/TSX capped composite index ETF.
No ESG filter, market cap weighted,
235 holdings and a 0.06% expense ratio.
It will almost certainly deliver
the market's return after costs.
XESG, the iShares ESG MSCI Canada Index ETF
favors companies with high ESG scores.
It has 129 holdings and an expense ratio of 0.22%.
MSCI has designed the index
to have an expected 1% tracking error.
So you expect to get the market return plus
or minus some random error.
If we wanted more sustainability,
we would need to increase the tracking error budget
and expect higher fees.
For example, the Desjardins RI Canada
low CO2 index ETF has 63 holdings,
more exclusions and stricter ESG criteria.
It has an expense ratio of 0.29%.
As we move along this continuum of trade-offs,
the higher costs might be worthwhile
if the result is a portfolio that increasingly aligns
with your views and values,
but this is one of the biggest problems
that sustainable investors face.
There is a huge difference between investing in a product
with ESG green or sustainable in its name
and investing in a way that aligns with your values.
Even the rating agencies,
that determined the ESG scores
don't agree on the definitions.
This was explored in a 2019 paper
by Florian Berg, Julian Kolbel and Roberto Rigobon.
They looked at ratings
from five prominent ESG rating agencies
and found that their ESG ratings have an average correlation
of 0.61 with a range between 0.42 and 0.73.
The disagreement is driven nearly equally
by differences in ESG definitions
and differences in how those definitions are measured.
For context, credit ratings
from Moody's and Standard and Poor's are correlated at 0.99.
We can look at the MSCI Canada IMI extended ESG focus index
as an example.
This index takes an integration approach
combined with total exclusions,
for tobacco, controversial weapons,
producers of, or ties with civilian firearms
and businesses involved in severe controversies.
All good things to avoid for a socially conscious investor.
Now here's the issue.
One of its largest holdings is Suncor,
a Canadian energy company specializing
in synthetic crude production from oil sands.
More than 16% of the index is made up of energy companies.
A different index provider
FTSE creates ESG indexes that exclude oil,
gas and coal companies.
They don't exclude downstream companies
like pipelines but it's still a step in the right direction.
This difference in ESG index construction
it should be a surprise
from the Berg, Kolbel and Rigobon paper,
we can see that energy specifically
is a major point of disagreement across ESG rating agencies
with an average rating correlation of only 0.29
at the energy category level.
The inclusion or exclusion of oil and gas companies
in an ESG index is only one example of a larger problem.
Name your social or environmental issue of choice
and different index providers
are likely to treat it differently.
Similarly, if an index provider treats one issue
the way that you would hope
they might not align with your views on other issues.
This is a big problem from two perspectives.
Investors might end up enduring the higher costs
of a sustainable portfolio
while owning companies that conflict with their values
and companies might be confused about which actions
they need to take to improve their ESG performance.
Approaching the sustainable investing problem
successfully ends up requiring precise management
of the trade-offs between implicit and explicit costs
and your specific set of views and values.
The perfect portfolio from the perspective of using values
couldn't end up being too under diversified
too expensive or otherwise impractical.
On the other hand,
the simplest cheapest and most diversified portfolio
is likely to conflict
on some level with the views and values
of most sustainable minded investors.
Step one for a sustainable investor
is understanding
that as long as there is dispersion in ESG preferences
sustainable portfolios have lower risk adjusted returns.
Step two is making a decision
about the acceptable level of portfolio trade-offs
in meeting the ESG preferences
that you have
where stronger ESG preferences
will generally mean less diversification
lower expected returns and higher costs.
Step three is probably the most important step.
It is verifying that the products that you have selected
truly reflect the views and values that have
motivated you to be a sustainable investor.
Thanks for watching.
My name is Ben Felix of PWL capital
and this is Common Sense Investing.
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