ESG’s lower (expected) returns | Financial Times

Happy Friday. Markets seem to have calmed down this week. We’ll see for how long. Meanwhile, a few words about two of the trickiest asset classes. I’m keen to hear your thoughts on either one: Robert.Armstrong@ft.com.

ESG’s low (expected) returns

I’ve been rattling on about the following argument for some time:

• The idea behind environmental, social and governance investing is that we should put our money into companies that behave well, and take it out of companies that behave badly, and that this will make the world better.

• Doing this is effective because it changes companies’ cost of capital. As money flows to “green” companies, their bonds and shares increase in price, and their cost of capital falls. Think of it this way: high bond and stock prices allow companies to raise the same amount of money at either a lower interest rate (bonds) or with less dilution (equities). For “brown” companies, the opposite applies.

• This makes the world better because with a lower cost of capital, green companies can profitably engage in projects that otherwise would have lost money, so more green projects get done. And the opposite for brown companies.

• But from an investor’s point of view, a low corporate cost of capital is nothing but a lower expected return. When you pay more for future cash flows, that lowers your expected return, all else being equal. Duh.

• So ESG investing only makes the world a better place by offering investors lower expected returns.

• When some fund salesperson with good hair tells you that you will outperform with ESG assets — “do well by doing good” — tell them to buzz off immediately.

This argument is not unique to me and is just basic finance. It’s really only interesting because so few people think about it. So I was pleased when a version of it was put forward in a paper by three professors — Lubos Pastor, Robert Stambaugh, and Lucian Taylor of the business schools at Chicago, Penn, and Penn, respectively — using a fancy economic “equilibrium” model (here is a tight summary of the paper, if you don’t like Greek letters and formulas):

Agents are willing to pay more for greener firms, thereby increasing the firms’ market prices and decreasing their costs of capital. Green assets have negative capital asset pricing model alphas [deviations from the expected market return], whereas brown assets have positive alphas. Consequently, agents with stronger ESG preferences, whose portfolios tilt more toward green assets and away from brown assets, earn lower expected returns . . . 

. . . agents’ tastes for green holdings increase firms’ social impact through two channels. First, firms choose to become greener, because greener firms have higher market values. Second, real investment shifts from brown to green firms, due to shifts in firms’ cost of capital

This is all intuitive. Here is the subtle bit. Expected returns do not always equal realised returns; sometimes green assets outperform. This happens when the market is surprised, either by companies’ customers suddenly wanting to buy more green stuff, or investors wanting to own more green investments. This will happen, for example, when there is awful news about the climate, and good climate news will have the opposite effect. The model just predicts that “green assets underperform brown over a sufficiently long period — a period long enough so that unexpected changes in ESG tastes average to zero”.

All of this is based on a model, though. What about the nasty old real world? 

Pastor, Stambaugh, and Taylor have just released a second paper with a more empirical bent. It points out that stocks with high environmental ratings (as measured by MSCI) outperformed those with low ratings by a total of 35 per cent between 2012 and 2020. They show this outperformance corresponds to increasing concerns about the environment, as measured by an index of media coverage: “green stocks tend to outperform when there is bad news about climate change”. 

The authors give a neat recent illustration of what rising environmental concerns look like. Germany recently began issuing “twin” government bonds, which are identical, except that the proceeds from one of the two go to green projects only. The green ones sell at a premium and therefore a lower yield; that’s your lower expected return. But the spread has widened recently, meaning the green bond has outperformed:

What does all this demonstrate? A simple point: betting on ESG to outperform is betting that the market still systematically underestimates consumers’ and investors’ taste for green products and assets — despite the fact that ESG products and funds have been very heavily promoted recently. If there are no surprises, ESG must underperform.

Emerging markets, part one

I was reading a Bloomberg article based on a conversation between my good friend/bitter professional rival John Authers and the investor Jeremy Grantham, and was really struck by a chart in it. It compared the performance of emerging market value stocks and the S&P 500 over two decades (via Bloomberg):

I have owned EM value stocks (through an index find) for a long time and it has not been much fun. I was surprised to see the long-term outperformance and I wonder what the prospects are now. It’s a key topic because EM stocks are cheap and have been touted recently as a way to participate in the reflation trade.

Here is the gap between price/earnings ratios of the S&P 500 and that MSCI EM value index. It hasn’t been higher since the tech bubble (via Bloomberg):

That makes EM value appealing, but there are a lot of moving parts to think about. Right now, three interrelated parts in particular:

1. What are the various emerging market currencies going to do? Over time, currency fluctuations have been as important to dollar or euro-based EM investors’ returns as earnings or other economic fundamentals. 

2. What will happen to real interest rates in the US as the Fed contemplates tapering asset purchases and raising rates? Negative US real rates have been a positive for EM, because they force investors to scour the rest of the world for better risk/return prospects.

3. When are the heterogenous countries that make up EM indices going to reach effective herd immunity though vaccination? On this point, Simon Quijano-Evans of Gemcorp Capital pointed me to this chart from Our World in Data:

Picking through these issues will take more than one edition of Unhedged, but I wanted to start the discussion and will continue it next week. Readers, are you betting for or against EM? Email me your views. 

One good read

The federal funds rate is obsolete and the Fed should target something else, says former Fed person.