{"id":208909,"date":"2024-07-08T09:46:18","date_gmt":"2024-07-08T13:46:18","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=208909"},"modified":"2024-08-12T15:18:14","modified_gmt":"2024-08-12T19:18:14","slug":"polluters-provide-higher-returns-than-non-polluters","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/ibkr-quant-news\/polluters-provide-higher-returns-than-non-polluters\/","title":{"rendered":"Polluters Provide Higher Returns than Non-Polluters"},"content":{"rendered":"\n

The article “Polluters Provide Higher Returns than Non-Polluters” first appeared on Alpha Architect<\/a> blog.<\/em><\/p>\n\n\n\n

While sustainable investments allow investors to express their attitude to social investment criteria, research (for example, about socially responsible mutual funds<\/a> and also about sustainability<\/a>) has found that the demand for sustainable investments is driven by both financial and nonfinancial motives. What does economic theory have to say about these different motives: Are they aligned or in conflict?<\/p>\n\n\n\n

Economic theory suggests that if a large enough proportion of investors choose to favor companies with high sustainability ratings and avoid those with low sustainability ratings (sin businesses), the favored company\u2019s share prices will be elevated and the sin stock shares will be depressed. In equilibrium, the screening out of certain assets based on investors\u2019 taste should lead to a return premium on the screened assets.<\/p>\n\n\n\n

In our book, \u201cYour Essential Guide to Sustainable Investing<\/a>,\u201d Sam Adams and I presented the evidence from about 60 studies that were entirely consistent with economic theory\u2014sustainable investors should expect lower returns. However, their investments also entail less risk because companies with high sustainability scores have better risk management and compliance standards. Their more robust 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 \u201csin\u201d premium. <\/p>\n\n\n\n

The Halo Effect<\/strong><\/h2>\n\n\n\n

Christina Bannier, Yannik Bofinger, and Bj\u00f6rn Rock, contributed to the sustainable investing literature with their study \u201cThe Risk-Return Tradeoff: Are Sustainable Investors Compensated Adequately?<\/a>,\u201d published in the May 2023 issue of the Journal of Asset Management, found that the preference for sustainable investment has been so strong that higher returns to less sustainable firms are sufficient to \u201covercompensate\u201d investors for the risk they bear\u2014the lowest-scoring firms produced the highest risk-adjusted returns. Thus, from a purely economic perspective, the optimal return-to-risk ratio is achieved for a portfolio that invests in the lowest CSR-rated firms.<\/p>\n\n\n\n

Summarizing, sustainable and impact investors<\/a> should expect lower returns from their investments.  However, some investors may struggle to align their social and investment preferences. The result could be that the \u201chalo effect\u201d\u2014a cognitive bias that leads investors to make decisions based on their overall impression of a product\/company\/investment, rather than on a careful analysis of its fundamentals\u2014<\/em>could lead sustainable and impact investors to believe that these investments have superior returns. That could lead to a loss of value creation.  <\/p>\n\n\n\n

Latest Research<\/strong><\/h2>\n\n\n\n

Yigit Atilgan, K. Ozgur Demirtas, and A. Doruk Gunaydin, authors of the May 2024 study \u201cDo Polluters Outperform Non-Polluters?<\/a>\u201d investigated whether industrial companies with higher toxic emissions outperformed those with lower toxic emissions. To measure pollution levels, they obtained plant-level chemical pollutants data from the Toxic Release Inventory <\/a>database maintained by the Environmental Protection Agency between 1991 and 2022. They aggregated by parent company the annual plant-level toxic emissions across all chemical categories. Their sample basically included NYSE, AMEX or Nasdaq firms while excluding excluded financial firms and firms listed for less than two years. They scaled total emissions (in pounds) in year t-1 by total assets, plant, property and equipment, sales or market value of equity disclosed by the end of March of year t. Emissions data for year t-1 were updated between July and September of year t in TRI. They then constructed portfolios at the end of September of year t to avoid look-ahead bias. They sorted all firms with positive scaled emissions in year t-1 into quintiles within 49 Fama and French industries<\/a> and then calculated monthly value-weighted returns of these quintiles from October of year t to September of year t+1.  Following is a summary of their key findings:<\/p>\n\n\n\n