Investors Follow Alpha Toward Sustainability

The University of California is among investors discovering that sustainable investing can be healthy for planet and wallet alike.


Earlier this month the University of California announced that it had sold $200 million worth of fossil fuels, specifically coal and oil sands assets, from its endowment, pension and working capital pools. On the surface the UC appears to have joined the dozens of other long-term investors that have decided to divest in response to stakeholder pressure. (There was much rejoicing.)

But this, friends, is different from and, dare I say, better than those other instances. Why? Because this is not a blanket divestment. This had nothing to do with politics or students. The Office of the CIO specifically cited the rising financial risks associated with these industries and framed the entire decision to sell in terms of the expected financial and commercial performance of these assets over the long run.

So while the UC decision may have been hailed as a divestment win by the media, the real victory here is for financial investors, as the UC move conforms entirely to commercial logics and, as such, fiduciary duties. Accordingly, the UC strategy is something that each and every institutional investor in the world can copy. (And I can tell you that many CIOs of peer organizations around the world have been reaching out to CIO Jagdeep Bachher to better understand how these decisions were made.)

Ninety-nine percent of institutional investors cannot (and would not) consider moving away from coal or oil sands due to political or moral imperatives (though that’s what Stanford did); they require financial and commercial metrics to do this without breaking fiduciary obligations. So, in my humble opinion, the victory here is that because this move was justified by risk and investment return, it is, in theory, a strategy that can be replicated by the masses. And that’s good for long-term investors and, I’ll say it, planet Earth.

As an adviser to the UC, I’ve been blown away by the work that the staff has done over the past 18 months to design, develop and build an investment-decision-making framework that incorporates these long-term risks in the context of a purely financial and commercial investment operation. The truth is that most investors have not yet figured out how to embed sustainability into their process. Most recognize that, in the long run, sustainability issues can and do affect asset prices. (With what’s happened this week to Volkswagen, it seems obvious that sustainability issues can have serious consequences for corporate valuations.) But the financial tools and rationales for taking these factors seriously have been missing . . . until just recently.

Apropos: New research from Harvard’s Mozaffar Khan, George Serafeim and Aaron Yoon shows that an investment portfolio made up of companies that perform well on sustainability factors that are material to their business — materiality is the key here — generates 6 percent of alpha. The paper is entitled “Corporate Sustainability: First Evidence on Materiality,” and It. Is. Awesome. Here’s a blurb from the authors:

“We use recent guidance by an accounting standard setter, namely the Sustainability Accounting Standards Board (SASB) to classify sustainability topics to material or immaterial according to industry membership. We find that firms with superior performance on material sustainability issues outperform firms with inferior performance on material sustainability issues in the future . . . [N]o prior paper has distinguished between sustainability issues that are material for a company versus all other less material sustainability issues . . .”

The punch line from the research is this: Companies that focus on material sustainability issues dramatically outperform those that don’t. Boom.

This finding is so elegant and obvious that you probably thought we all already knew and did this. Not true. There exist many standard setters and financial product providers that claim to include hundreds and even thousands of sustainability data points for each and every security, most of which are completely immaterial and unnecessary for understanding corporate behavior. It’s no wonder that nobody has found these factors to outperform, because most of the data doesn’t correlate with outperformance! We now know — thanks to this research and the good work of SASB — that it’s not the quantity of sustainability factors you tag assets with; it’s their relevance and materiality to a given industry.

Anyway, back to the UC’s decision to sell coal and oil sands. You can imagine (though you really don’t have to) that when UC analysts looked at coal and oil sands, they found some material sustainability issues that led them to sell. And so, based on the logic of the Harvard paper, the UC would seem to have just eliminated a 2.9 percent drag on its portfolio. Bam! But it doesn’t stop there. If the fund in turn reinvests that cash in industries less prone to climate change risk factors and in companies that perform well on SASB’s material factors, alpha on this strategy could be 6 percent. That’s literally un-ignorable!

In a world that many expect will not deliver beta returns sufficient to meet anticipated return targets, even the most commercially oriented capitalists — those with ice pumping through their veins — have to pay attention to that kind of financial outperformance. And that, dear readers, is precisely what’s so exciting about all this.