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Scholarly Pursuits

The Unintended Consequences of Green Investing

ESG investing might create inefficiency, Zhan Xintong’s research shows

The rise in sustainable investing brings with it pitfalls, according to fresh CUHK research, particularly when it comes to the pricing of stocks. The greater the Environmental, Social and Governance (ESG) credentials of a company, the less likely its shares are to reflect the company’s underlying value.

Fundamental analysis of the stock market will yield signals that a company’s shares are either overpriced, suggesting investors should sell, or underpriced, suggesting investors should buy. But these signals are not heeded by investors seeking strong ESG holdings, according to the findings of CUHK professor Zhan Xintong. That leads to inefficiencies in trading.

‘Socially-responsible institutions underreact,’ Professor Zhan says. ‘They don’t buy that much, and they don’t sell that much.’

Once socially responsible investors find a company they like, in other words, they are loath to sell it. They may also ignore companies that otherwise would have appealed to their investment committee, but that fail the ESG screening test.

Zhan published her findings in the paper ESG Preference, Institutional Trading, and Stock Return Patterns. The Journal of Financial and Quantitative Analysis plans to publish the paper, which is also available on SSRN, the Social Science Research Network.

Ignoring trading signals does not necessarily mean that the performance of the shares is better or worse. It simply means that their trading price is less volatile, more predictable, and at times not as efficient at reflecting the underlying fundamentals of the company.

A stock ‘can be overpriced and it can be underpriced,’ Professor Zhan says. ‘Both directions are possible given that signal.’

The popularity and rising prevalence of ESG investing therefore introduces new characteristics to the broader stock market.

‘We are not saying that ESG is good or bad,’ Professor Zhan notes. ‘We are only saying it delays and slows down the mispricing, which in the short run leads to inefficiency. So from a market efficiency point of view, it is bad.’

The more socially responsible investors that own a stock, the greater the inefficiency. That also means the predictability of the ESG-favorable stock is greater, too, almost triple the predictability of a stock that doesn’t classify as an ESG company.

From 1995 to 2016, Sustainable and Responsible Investment has increased nearly 14-fold

Professor Zhan, who is an assistant professor of finance and real estate in CUHK’s Faculty of Business Administration, examined US institutions for the study, since the data is most extensive on that investor universe. She won a CUHK Young Researcher Award for 2020–21 for her work.

‘I would expect the results to be even stronger in Europe,’ Professor Zhan speculates. ‘Institutions in Europe are stronger in terms of their ESG preference.’

Retail investors have a stronger influence on Asian markets. So the trends may not be as pronounced in Asia as they are in the US, since retail investors do not often act collectively in their preferences, particularly when it comes to ESG. Asian markets are choppier, with more trading signals and ‘noise’ than their counterparts elsewhere in the world.

The paper looked at trading between 2004 and 2016, so the trends have likely strengthened in the five subsequent years, as ESG investing becomes even more popular. Professor Zhan also looked at data from 1996 to 2003, when ESG investing was not yet a trend, and there was no such trading pattern.

‘Global warming and the pandemic are really changing our world view,’ Professor Zhan notes. ‘The socially-responsible institutions are gaining more power. So the findings we have should apply to recent years in an even more pronounced way.’

Professor Zhan and her team members <em>(from left)</em> Li Shuting, Zhang Yaojia, Zhang Weiming and Wang Yajing

The research is the first of its kind to look at the relationship between ESG factors and stock-market trading behaviour. It suggests the need to hone asset-pricing theory. In fact, a strong ESG showing may actually drive the fundamental value of a company higher.

‘It reminds people of some unintended consequences of socially-responsible investing,’ Professor Zhan says. ‘But it also reminds them of the importance to build up a new pricing model.’

The researchers have presented their findings to institutional investors such as Schroders, AXA Investment Managers and the China-focused quantitative investment house Rayliant Global Advisors.

‘They are thinking about how to improve the performance of their portfolio and strategy,’ Professor Zhan says, and using the paper to explain ESG trends to their investors. ‘At least they understand why their performance doesn’t outperform in the short run. But their investors get more utility and are happier investing in positive, good companies.’

Professor Zhan and her team are also working on testing these theories in the bond and options markets. She is also interested in how carbon performance and carbon-emission levels affect asset pricing. The expectation is that green credentials also lead to greater trading inefficiencies there.

‘The ESG performance plays an intermediary role,’ she concludes. ‘It’s not a direct impact, but you cannot ignore it.’

By Alex Frew McMillan
Photos by Eric Sin

Zhan Xintong ESG investment sustainable and responsible investment Department of Finance Faculty of Business Administration