Sustainability in the Time of Uncertainty

Nachhaltigkeit und Unsicherheit im Finanzmarkt – was hat das eine mit dem anderen zu tun? Wir untersuchen den Schock der COVID-19 Pandemie für den globalen Finanzmarkt und zeigen, dass Aktien, die als nachhaltig klassifiziert sind, sich während des Abschwungs am widerstandsfähigsten zeigen. Die überdurchschnittliche Entwicklung kann in der ökonometrischen Analyse in drei erklärende Komponenten aufgegliedert werden, Unsicherheit, Anlegerstimmung («Sentiment») und eine idiosynkratische Nachhaltigkeitskomponente. Ein Experiment zu den Nachhaltigkeitspräferenzen von Investoren, das einmal vor und ein zweites Mal während der Krise durchgeführt wurde, bestätigt, dass Nachhaltigkeit während eines Börsencrashs geschätzt wird. Für Anleger können sich diese Einsichten als höchst relevant erweisen: Auch wenn gewisse Investoren argumentieren, dass nachhaltiges Kapital nur vage zu Umwelt und Gesellschaft beiträgt, hilft es dem Portfolio in Zeiten erhöhter Unsicherheit.

Sustainability and market uncertainty – what does one have to do with the other? Resilience is the answer.

The COVID-19 pandemic has led to one of the most severe and unexpected stock market crashes in a century, driven by rising fears and a global economic shut-down. At the time of writing this blog, the market is well underway its recovery phase, at least in the short-term, but the picture was rather bleak just a few months ago. Global markets during the downturn between 20 February 2020 and 18 March 2020 became extremely volatile, reporting severe contractions and seeing a drawdown of at least 30% during the crash.

In the years leading up to this crash, the increasing preferences of individual and institutional investors for so-called sustainable investments — which is the general term for sustainable and responsible investment and any other investment that incorporates ESG (environmental, social and governance) criteria in the investment process — have been extensively documented. The COVID-19 induced stock market crash presents a natural experiment for stress-testing the extent and nature of these preferences when uncertainty increases, especially given that the recent crash is arguably a social phenomenon characterized by acute uncertainty.

Indeed, sustainability seems to have captured investors’ attention during the recent crash. Figure 1 displays the price development of the S&P 500, the VIX Index as a proxy for the stock market’s expectation of volatility, alongside of the Google Trends search volume of the term ‘’ESG’’ as well as ‘’Environmental, Social, and Governance’’ on a weekly basis over the one-year time period April 2019 to April 2020. The Figure indicates a recent spike in the popularity of this search query in Google Search across various regions and languages, which to a certain degree matches the stock market crash and the increase in perceived risk attitudes.

Figure 1: Uncertainty and Sustainability Sentiment during the COVID-19 crash

But who tells us which stock is sustainable? Classifying stocks based on sustainability is a tricky matter. The way it usually works is that private, and thus far unregulated, rating agencies assign scores to stocks, which investors then use in their investment process. Recent research documents a significant disagreement between such ESG scores across rating agencies, which makes it hard to trust the type of information they encode. One way to overcome this issue, at least to a certain degree, is to aggregate ESG scores from several rating providers to form a more exhaustive view. We used such an aggregate score to divide stocks into 5 different baskets, based on their sustainability ranking, and find clear-cut and – to me on a personal level – surprising results: sustainably rated stocks significantly outperform lower rated stocks during the crash. Figure 2 shows the average cumulative abnormal returns per ESG basket, with Quintile 1 containing the highest, Quintile 5 the lowest rated stocks, as well as for firms that are not covered by the rating agencies we refer to.

Figure 2: Cumulative abnormal returns sorted by ESG rating

So why did sustainable stocks exhibit more resilience during the crash? We contend that sustainability and stock uncertainty are inextricably linked, and that this relationship is magnified in times of market turmoil.  With this in mind, we derived an econometric decomposition of ESG scores based on three indicators capturing (i) uncertainty, (ii) market sentiment, and (iii) an idiosyncratic sustainability component, and show that the resilience of sustainability during the downturn is largely driven through the uncertainty channel, and mildly through the idiosyncratic factor. Figure 3 illustrates this main insight. The blue line shows the daily coefficients of the regression of cumulative abnormal returns of U.S. stocks on ESG scores. As the stock market started to collapse, an increasingly strong association between ESG and abnormal returns prevails, with a unit increase in the ESG score leading to an increase of over 10 percentage points in abnormal returns towards the end of the crash. After controlling for a range of financial fundamentals, we run the same regression on the three econometrically derived explanatory factors of ESG scores, and plot the evolution of the coefficients (in absolute value) during the crash. The main contribution to resilience of ESG in terms of estimated abnormal returns clearly stems from the uncertainty component, while the idiosyncratic sustainability factor plays a comparably mild role. Resilience of sustainable stocks thereby stems from their intrinsic low uncertainty profile, considerably more so than from financial fundamentals or the idiosyncratic ESG component.

Figure 3: Contribution to cumulative abnormal returns by component

The market thus views sustainability as being less associated with uncertainty, with sustainability scores given to stocks inherently encoding information about stock-related risk and ambiguity, making them an efficient predictor for individual stocks’ ability to respond to market uncertainty. For investors these insights can prove highly relevant: sustainable equity, even if some may argue that it at most vaguely contributes to environment and society, significantly contributes to portfolio resilience in times of heightened uncertainty.

The results summarized in this blog entry are based on the following working paper that I have co-authored with Dr. Julia Meyer, Department of Banking and Finance at the University of Zurich:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3597700