Excluding fossil fuel companies from a portfolio comes down to an active bet against the oil price. This exposes the portfolio to significant risk of underperformance in the short and medium term.
In recent years, the growing sense of urgency about climate change has intensified the drive to tackle the issue and mitigate its effects. To this end, the financial industry is seen as having a critical role to play in enabling decarbonization. Against this backdrop, several large institutional investors have either divested from fossil fuel stocks or announced their intention to do so.1 That said, it is worth being cognizant of the portfolio implications of precluding investments in such companies.
In our research,2 we examined the effect that the exclusion of fossil fuel stocks has on the systematic risk exposure of equity portfolios. We focused on macroeconomic risk factors that explain large differences in short and medium-term returns. Our sample period spanned from January 1995 to December 2021. Given that fossil fuel divestments tend to focus on oil and gas companies, we used the energy industry as a proxy for our study. Figure 1 shows that the sector exhibits an exceptionally high beta towards changes in oil prices, i.e. fossil fuel prices.
To get a better feel for the economic relevance of the oil exposure of the energy sector, we examined how it performed during oil bull and bear markets. We saw that the bull and bear scenarios accounted for 61% and 39% of the sample period, respectively. As depicted in Figure 2, the energy industry strongly outperformed during oil bull markets and severely underperformed during oil bear markets, in line with its high oil beta.
Surprisingly, the materials sector delivered a similar pattern of returns, despite having a much smaller oil beta. This result suggests that it could serve as a good substitute for the energy sector. However, it is doubtful whether it qualifies as an acceptable alternative for investors who wish to divest from fossil fuel stocks, because, like energy, the materials sector has high carbon emissions and a range of environmental issues.
The next best hedge appeared to be the industrials segment, but the sector generated significantly less pronounced returns during oil bull and bear regimes. Moreover, it also contains many firms with high carbon footprints, such as airplane manufacturers and airline companies. The remaining industries exhibited the opposite sensitivity to oil price changes, i.e. they underperformed during oil bull markets and outperformed during oil bear markets.
Aside from the equity market, oil futures present another hedging option. By systematically going long oil futures, positive returns are achieved during oil bull phases and negative returns during oil bear regimes, similar to the market-relative performance of the energy sector. However, if the purpose of excluding energy stocks is to divest from fossil fuels, then oil futures are unlikely to be considered as an acceptable solution.
Therefore, divesting from fossil fuel stocks entails actively betting against oil, as it seems as if this risk cannot be hedged without taking on other (implicit or explicit) forms of fossil fuel exposure.
We also investigated how various industries performed in energy bull and bear markets. Although the results were generally similar to the oil bull and bear market phases (there is a 74% overlap), the two regime classifications are not entirely synchronous. Roughly speaking, the energy sector generated strong outperformance until mid-2008, after which it became a steady underperformer. The bull and bear scenarios each comprised 50% of the sample period.
Interestingly, the energy industry had almost identical returns compared to the market over the full sample period. This suggests that energy stocks offer neither a premium nor a discount in the very long run, consistent with findings from other research.3
Figures 3 illustrates how the energy sector predictably exhibited more pronounced outperformance and underperformance during energy bull and bear markets respectively, than it did for the oil bull and bear regimes. Once again, materials emerged as the best hedge, albeit to a lesser extent than in the oil scenarios. In line with the previous results, none of the other sectors provided a very effective substitute for energy. In fact, most even exhibited an opposite performance pattern.
Furthermore, we explored what impact the exclusion of the energy sector from a global equity portfolio would have on its returns over a decade. We saw that over the most recent period, from 2011 to 2020, which was mostly an oil and energy bear market, the preclusion of investments in energy stocks would have boosted the annualized return of the portfolio by almost 1%. However, over the preceding decade from 2001 to 2010, which was mostly an oil and energy bull market, it would have lowered the performance by more than 1% per annum.
Thus, divesting from fossil fuel stocks can have a substantial impact on equity portfolio returns over typical evaluation horizons.
We conclude that divesting from fossil fuel stocks comes down to an active systematic bet against the oil price that is probably hard to avoid. And while excluding these stocks appears to have a neutral effect on long-term expected returns, it does make a portfolio vulnerable over the short and medium term to significant underperformance during oil or energy rallies.
1 Bradford, H., September 2021, “Dutch fund PME completes fossil-fuel divestment”, Pensions & Investments; Pielichata, P., October 2021, “ABP to divest from fossil-fuel stocks immediately”, Pensions & Investments; and Steyer, R., December 2021, “3 NYC pension funds divest $3 billion from fossil fuels”, Pensions & Investments.
2 Blitz, D., January 2022, “Betting against oil: the implications of divesting from fossil fuel stocks”, SSRN working paper.
3 Sireklove, J., 2016, “Fossil-free investing”, Journal of Index Investing; Trinks, A., Scholtens, B., Mulder, M., and Dam, L., April 2018, “Fossil fuel divestment and portfolio performance”, Ecological Economics; and Plantinga, A., and Scholtens, B., 2021, “The financial impact of fossil fuel divestment” Climate Policy.
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.