While sustainable investing continues to gain momentum, some deeply ingrained but also deeply flawed views of risk and return in academic finance still make it look like a fad. Research like this may seem arcane and its assumptions innocuous, but the implications are not. When peer reviewed, award-winning research from top-ranking business schools say that sustainable investing is a “preference” which reduces investor returns, it becomes powerful ammunition for the remaining holdouts against sustainable investing.
Recently, the Jacob Levy Center at the Wharton School gave an award to a paper entitled “Sustainable Investing in Equilibrium,” which found that
“In equilibrium, green assets have low expected returns because investors enjoy holding them and because green assets hedge climate risk. Green assets nevertheless outperform when positive shocks hit the ESG factor, which captures shifts in customers’ tastes for green products and investors’ tastes for green holdings. … The ESG investment industry is largest when investors’ ESG preferences differ most. “
In other words, investing in green or sustainable assets is a matter of taste or preference which reduces returns, unless other investors change their taste or preferences. The authors came to this conclusion by dividing the investment universe into green and brown assets, where:
“Green” firms generate positive externalities for society, “brown” firms impose negative externalities, and there are different shades of green and brown.
Then, investors can choose the ones they like:
“Agents differ in their preferences for sustainability, or “ESG preferences,” which have multiple dimensions. ”
Finally, after a lot of sophisticated financial mathematics, they conclude that
Investors with stronger ESG tastes earn lower expected returns, especially when risk aversion is low and the average ESG taste is high. Yet these investors give up less return than they are willing to in order to hold their desired portfolio. If either kind of ESG concerns strengthen unexpectedly over a given period of time, green stocks can outperform brown stocks over that period, despite having lower alphas.
In other words, green or sustainable assets have lower returns, which their investors are happy to accept because of other benefits.
An innocuous statement, until you realize that it could then lead, very naturally, to an argument that since fund managers are fiduciaries investing other people’s money, they shouldn’t bring in their own political and social agenda. This was the exactly how the Department of Labor curbed sustainable investing last year, despite opposition from the investment management industry itself.
How did this chain of thinking come about? Through these assumptions:
The model considers a single period, from time 0 to time 1, in which there are N firms, n = 1, . . . , N. Let r ̃n denote the return on firm n’s shares in excess of the riskless rate, rf , and let r ̃ be the N × 1 vector whose nth element is r ̃n. We assume r ̃ is normally distributed:
r ̃ = μ + ε ̃ ,
Most people would glaze over by now. Finance professors would probably skip over at something they’ve seen thousands of times. But these few lines, which represent the standard thinking of academic finance, make some very strong statements about how the financial markets operate:
- The relevant returns are those over short time horizons
- Prices (and returns) of investments follow a normally distributed, random walk without any long-term trend.
With these assumptions, climate change no longer matters. Nobody has to deny it. It’s just that over short enough time horizons, you won’t see the difference between sustainable assets and non-sustainable ones.
In reality, though, both assumptions are false. The world’s largest pools of investment capital, the long-term pension funds and bondholders, are not looking at short time horizons. They have long-term actuarially determined investment goals to pay their pensioners and claims holders. To meet those goals, they invest based on long-term projected returns and risks from different investment assets.
Furthermore, there really are long-term trends in the real world and in investing. Climate change is a big one that will affects all investments and their returns. The Paris Climate Agreement’s 2050 goals are less than 30 years away. Long-term corporate and governments bonds being issued today have maturities after 2050. The retirees who need to be paid in 2050 are in their thirties and forties already. That means the big long-term investors need to get paid back in a world buffeted by climate change.
As a result, major pension funds and long-term bond investors are banding together under groups like the Net Zero Alliance and Asset Owners 100+ to make climate a core issue. They’re not doing this because it makes them happy to own green assets. They’re doing it because “sustainable investing” means literally that–“sustainable” as in “able to be maintained at a certain rate or level.” It’s about investing in businesses that could keep going. It’s about investments that produce returns over the long term. It’s about getting paid back.
In other words, sustainable investing is not a preference shift but a matter of survival.
The opposite of “sustainable investing” is liquidation. If you invest like this, you’re buying into a going out of business sale. The cash flow, P/E ratio, EBITDA multiples might look great, but eventually there won’t be anything left. You’re investing in what Warren Buffet would call the “cigar butt,” something you could find on the street and take one more drag out of.
We can and need to fix this. The business case of making investments sustainable in the face of climate change and the resulting government policies and social changes has been well established. It should be incorporated into the formal mathematical analysis of academic research. Models should account for the long-term effects of climate change in asset returns. This could start with real estate, whose climate risk is easier to assess, and bonds, whose long-term default rates could be modeled, and move to different sectors of equities based on their specific exposures. These models could then, in turn, help investors make better investments decisions.