Earlier this year, the U.S. Securities and Exchange Commission adopted rules requiring public companies to disclose climate-related risks so investors can make informed decisions about them; meanwhile, more than a dozen states have gone in the opposite direction, arguing that public pension funds should only consider financial returns and passing legislation that seeks to prevent funds from boycotting fossil fuel investments or from making decisions based on ESG—environmental, social, and governance—factors.
A new study co-authored by Yale School of Management Professor Edward Watts—which was cited in the footnotes of the new SEC rules—offers something for both sides of the argument. Individual retail investors, the study finds, already make investment decisions based on ESG-related factors—but for what seem like purely financial reasons.
“Retail investors are already trading around this stuff in their personal portfolios, so why should pension funds be any different?” Watts asks.
For their new paper, Watts, Stanford PhD student Qianqian Li, and Christina Zhu of the Wharton School examined the behavior of retail investors around more than 54,000 ESG-related news events for nearly 3,300 publicly traded firms between 2015 and 2022. Over that time, they found, retail trading increases by 6% on ESG news days compared to non-event days (and by 8% post-2020). They then went further to try to determine why trading increased: Are investors motivated by non-pecuniary reasons, like a desire to be socially responsible? Or are they instead driven by a news event’s potential impact on their returns?
The evidence in the paper points to the latter hypothesis: According to the researchers’ data, investors purchase securities when the implications of the news are positive for their stock’s performance, and they sell when the implications are negative.
For example, more retail investors sold Boeing stock than bought it following the company’s settlement of the 737 Max scandal—an ESG event with negative implications for performance that led to a 4% stock selloff. But they also sold shares of Occidental Petroleum after the company announced increased investments in clean energy, an ostensibly positive ESG event that also coincided with a drop in its stock price.
In his class on ESG investing, Watts says, he offers an extreme hypothetical to drive home the point. “It would be very pro-ESG to raise your employees’ salaries by 500 percent,” he says. “But the stock price is going to drop significantly. No investor is going to like that.”
The paper makes several contributions to the literature on ESG investing. Many prior studies had been based on surveys that asked retail investors what they would do in certain situations or studied narrow asset classes of only sustainable investments; Watts’ paper shows what investors actually do across the broader universe of equity investments. Also, previous empirical evidence was mixed on whether retail investors cared about ESG-related information or whether they would give up financial returns in pursuit of ESG-related goals; Watts’ paper shows they do care about ESG events but mostly in the context of how they will affect their portfolio.
“There’s been a tremendous amount of debate circling around these issues, but I don’t think we had much generalizable empirical evidence,” Watts says. “This is a simple exercise: Are people consuming this information through the news and trading around that? We’re trying to infer, in the aggregate, what people really seem to care about and how much they really care about it.”
Watts and his co-authors also compared how much activity takes place around ESG-related news events compared to more traditional financial disclosures; overall, they find that investors respond more to ESG news than to analyst forecasts and dividend announcements but less than they do to earnings announcements or management guidance. But, when comparing events with about equal price reactions, the authors find that the response to ESG and earnings announcements are similar.
The term ESG has become weaponized. If we just accepted that this stuff is not very special, we wouldn’t have a lot of these debates.
In other words, investors treat ESG information like they do any other information that might affect their returns. Quoting Alex Edmans of the London Business School, the authors write that “ESG is both extremely important and nothing special.” They conclude that bans on considering ESG may be “misguided” and “violate fiduciary obligations.” But making broad claims that many retail investors care about ESG for non-pecuniary reasons also “may be inadvisable.”
Watts says that politicization of ESG has led to unnecessarily contentious debates in state legislatures and among financial regulators.
“The term ESG has become weaponized,” he said. “If we just accepted that this stuff is not very special, we wouldn’t have a lot of these debates.”
