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Views of pension fund participants important for the discussion on ESG

09-02-2015 | Insight Social preferences in sustainability can play a role in investment decisions, says Paul Smeets PhD, an expert in behavioral economics and finance. Quantitative investors should pay attention too.

Paul SmeetsPaul Smeets is an assistant professor in Finance at Maastricht University and is currently a visiting scholar at the University of California San Diego. His research work is centered on the behavior of socially responsible retail investors. The central question in his research work is: “How do social preferences influence the behavior of investors?” In writing his PhD dissertation* he cooperated with Robeco, ASN, Triodos, Loyalis and Deutsche Bank to find out why Dutch private investors were investing in sustainable mutual funds.

What surprises came out of your research on why people invest in sustainable mutual funds?
“A large group of retail investors expected returns to be lower than those of other mutual funds, but they still wanted to invest in these sustainable funds, because they had an intrinsic social motivation. I found these results interesting for two reasons.”

“First, there is no evidence that returns of sustainable funds are actually lower. Second, in portfolio theory the assumption is that investors only look at risk and return, but we found that investors also look at another factor and are prepared to make a trade off with return.”

“The influence of intrinsic social motivation is well documented in other areas. For example, lawyers are less willing to do pro-bono work if they receive a reimbursement. They no longer see it as a form of charity, but as business. I suspect that this phenomenon also has implications for the marketing of sustainable funds. For example, the marketing of micro credit funds might be more effective if, when these are sold, the emphasis is placed on the charitable attributes instead of only on performance.”

Does your study have implications for pension funds?
“My research shows that sustainability is important for many private investors and in a broader context as well, because most people in the Netherlands are members of pension funds. I expect that they too would like sustainability to be included in the investment criteria.”

“The views of pension fund participants should play a role in the discussion on incorporating ESG (environmental, social and corporate governance) preferences into investment criteria. Unfortunately, the decision over whether to invest sustainably or not is made without consultation with the participants. If participants are only interested in risk and return, then asset managers should focus on the impact of ESG criteria on these parameters. But if many pension fund participants feel that ESG is important in itself, the role of sustainable investing could be larger.”

How can the financial industry accommodate investors with a strong social motivation?
“When drawing up their risk profiles, private investors and pension scheme participants in the Netherlands are already asked about their risk tolerance. These profiles are in some cases obligatory by law. It would also be easy to include a few questions on sustainable investing at this stage. However, this has not been the case up to now and so the opinions of many people on this issue are not being heard.”

Can the social preferences of sustainable investors have an impact on asset prices?
“Yes, the influence of ESG is increasing and I expect its impact on asset prices to increase as a result. Therefore, quantitative investors should pay attention too.”

“There are two reasons why a mismatch may occur between a stock’s price and its fundamental value. The first reason is that sustainable investors do not process all the available information. For example, they may have difficulty in handling soft data such as how companies treat their employees. Second, sustainable investors prefer or dislike certain groups of stocks, which can drive their prices up or down.”

“We can already see such an influence on the prices of certain ‘sin stocks’, shares of companies that are active in alcohol, tobacco or weapons. Some private and institutional investors do not invest in these stocks. In the short term the impact on stock prices is negative, while in the long term these stocks offer a higher dividend yield and returns are expected to be above average.”

What are the barriers to implementing ESG?
“There is still a lot of work to be done in deciding what criteria are relevant to ESG. First, definitions are not clear and can change over time. A company may have an excellent environmental record, but may also use child labor. On the other hand, the definitions relating to ‘sin stocks’ are much clearer, which is why we can already see an impact on prices.”

“Second, nearly all companies want to have a good reputation with regards to ESG. This phenomenon is sometimes called ‘green washing’ and it makes it more difficult to differentiate between companies. Furthermore, sustainable rating companies have limited analyst capacity to investigate companies thoroughly. Their analysts need to cover a large number of companies. However, as interest in sustainability is gaining momentum, I expect that more capacity will become available for researching companies’ sustainability.”

Which areas will be important in future research?
“We only just started investigating clients’ motives for investing. I look at trading data, which gives insight into the choices that investors make. But these data do not reveal much about the motives of investors, which often extend beyond risk and return. Therefore, I prefer to also include questionnaires and field experiments in my research. A combination of different data sets allows you to get a better picture of what drives investors.”

* Research Paul Smeets


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