Lecture 5 Flashcards
Adaptive Market Hypothesis - Schoenmaker & Schramade
Efficient market hypothesis (EMH) & disadvantages
All information including ESG is already priced or irrelevant
- Over-simplificated
- Market participants change over time
- Dispersion of information is not immediate
Adaptive Market Hypothesis - Schoenmaker & Schramade
Adaptive market hypothesis (AMH)
Pricing ESG information depends on the number and quality of market participants that take ESG seriously
- Much more plausible
- Non-predictive
- Non-model, as it don’t try to explain reality and don’t set predictions that help investors to make choices
Adaptive Market Hypothesis - Schoenmaker & Schramade
Alfa-beta debate effects ESG
An active investor picks individual stocks and bonds based on such fundamental analysis
- Alpha investing: translating ESG factors to ESG fundamental analysis
Someone who believes in the EMH theory wouldn’t do that
- Beta investing: passively buys market, as it is impossible to beat market as all information is included
Adaptive Market Hypothesis - Schoenmaker & Schramade
Alfa-beta debate effects ESG
Evidence shows
- ESG alpha is empirically hard to establish, alternatives rarely beat the market
- Some negative ESG stocks outperform, but are explained by FF5F factors
- Positive ESG stocks also outperform, but are explained by “quality factors”
Pedersen - CAPM with ESG preferences
Assumptions
Deviate from CAPM, there are three types of rational investors
o ESG unaware = Traditional Investing
o ESG aware = SI 1.0 and 2.0
o ESG motivated = SI 2.1 3 dimensional target max(I=F+S+E)
Pedersen - CAPM with ESG preferences
Conclusions
E and ESG stocks: Higher demand from investors made them expensive (high valuation)
S stocks: Investors identify and buy non-sin. But they do not show better returns, because sin stocks have good returns
G stocks: Investors hardly identify them. Stocks perform well, because the firms do well and they are cheap
Berk & van Binsbergen
Question
Effect of exclusion of sin-stock and fossils on the cost of capital of affected firms
Berk & van Binsbergen
Idea
What happens when an ESG minded investor sells it stocks?
- The new owner can control shareholder rights
- The firm faces a smaller buyer base for its financing > higher capital cost > lower growth rate (ESG result)
Berk & van Binsbergen
Background
Assumptions
- Assumption 1: In the economy exist: “clean” stocks and “dirty” stocks
- Assumption 2: The investment community consists of ESG investors (own only clean stocks) and others (own all stocks minus those owned by ESG investors)
- Assumption 3: ESG investors will own a tangency portfolio of clean stocks and other investors will own a tangency portfolio of all other stocks (market portfolio)
Berk & van Binsbergen
Debates
Sin or fossil firms usually don’t need external capital, as they finance from their internal high incomes
Therefore cost of capital (share price) will not affect them
Berk & van Binsbergen
The test and conclusion
- Regress prices of FTSE USA 4Good on a dummy that represents inclusion/exclusion in the index
o No effect on the cost of capital - The impact on the cost of capital is too small to meaningfully affect real investment decisions
- Only the majority investors will turn to ESG, this will have a significant impact
- No ESG result, even if sin companies will go to market, the cost of capital won’t be affected
Berk & van Binsbergen
Background
Can all other investors own the market portfolio?
- No, some other investors can still own the market portfolio, but not all of them
- Other investors choose the market portfolio, because it is the ideally diversified, but are forced to buy deviate
This deviation > Increase risk > Seek compensation > Better return on dirty stocks.
Berk & van Binsbergen
E(R) difference between dirty and clean stocks (dirty premium)
- Undiversification effect increases risk
- Negative correlation between dirty and clean stocks
o Lower correlation of dirty stocks moves them further away from the market portfolio
o This is unwanted as they have already an ideal portfolio, and only go away from it
Pedersen - CAPM with ESG preferences
Implementation
- ESG motivated investors optimize the max Sharpe Ratio and ESG outcome, based on ESG scores
- Then, they will create an ESG-efficient frontier, based on the previous tangency portfolios
- ESG unaware will end up with a suboptimal portfolio in the ESG adjusted CAPM
- Investors with strong ESG preferences will pick a portfolio with higher ESG scores and lower Sharpe Ratios
- More ESG motivated investors > more demand > higher prices > lower return
Pedersen - CAPM with ESG preferences
Measuring ESG data
E: carbon emission per revenue
S: exclude sin stocks
G: low accrual
ESG: the MSCI ESG score
