Sin stocks and exclusion

In late October, the UK regulator FCA published its suggestions for the UK Sustainable Disclosure Requirements (SDR). Once in effect (expected for mid-2023), funds sold to retail investors in the UK will have to have one of three sustainable funds labels to call themselves ‘green’ or ‘sustainable’. Not only is this the first official fund rating system for sustainable funds in the world, but the UK regulator is also setting the bar for what is a sustainable fund higher. On the one hand, the FCA is clear that it does not consider ESG integration in the investment process alone sufficient to call a fund sustainable. It considers ESG integration an integral part of the fiduciary duty of a fund manager! Tell that to the SEC and US fund managers… But also, the FCA is clear that simply excluding some stocks from the universe is not going to be enough to call a fund (or an index) sustainable. This brings me to my favourite hobby horse in ESG investing, namely the futility of exclusions and negative screening.

People who believe in rational market pricing theories claim that excluding stocks from a portfolio should lead to lower share prices and hence higher expected returns in the future if the companies remain in business. David Blitz and Frank Fabozzi have long thrown a bucket of cold water on this myth and showed that once controlled for factors like profitability and investment, sin stocks do not have higher returns than other stocks.

Advocates of exclusion and negative screening, on the other hand, claim that excluding sin stocks from a portfolio pushes their prices lower, increases their cost of capital and in the long run, forces them to change their business or go bankrupt. And that’s the claim that Robert Eccles and his colleagues just threw a bucket of cold water on.

The new research on US companies between 2000 and 2019 found that at first sight, sin stocks do seem to have lower valuations and higher returns than non-sin stocks. However, when crucial factors like profitability, investment activity, and financial leverage are taken into account the valuation of sin stocks was statistically no different than the rest of the market. To give you an idea, valuations of sin stocks were some 0.004% lower than the rest of the market when controlled for these fundamental attributes of companies. However, it is also worth noting that if the analysis is restricted to the most recent decade from 2010 to 2019, the valuation of sin stocks was statistically significantly lower than the rest of the market which indicates that there might be an emerging valuation impact in the market. But even if there is a difference in valuation, the researchers did not find a statistically significant difference in returns between sin stocks and the rest of the market. In fact, the monthly return of sin stocks was some 0.12% lower than the rest of the market (1.46% annualised). Not here that sin stocks, particularly in the energy space generally performed very poorly in the last decade, so this return difference may simply be an artefact of the commodity cycle turning south.

One thing the researchers found was that the cost of debt was somewhat higher for sin stocks, something that I have written about before. But the cost of equity is roughly the same and, most importantly, the chances of a sin stock exiting the market are no different than for any other stock. In other words, sin stock exclusion does not lead to higher or lower returns in the portfolio, it does not penalise companies in the form of higher or lower valuations for their stocks and it does not force them out of business. Or to summarise, excluding sin stocks from a portfolio is largely ineffective.