Researchers in behavioural finance have shown that investors’ “sentiment” can impact stock prices. What about “green sentiment”, what is special about it?
It is true that market or speculative “sentiment” (i.e. investors’ change in preferences that are not related to fundamental information) on asset returns and firms’ financing and investment decisions has been widely studied (see for example Baker and Wurgler, 2006). But despite the growing importance of green finance for both investors and policy makers, our understanding of the influence of environmental concerns on financial markets and corporate decisions remains limited. Several theoretical works indicate that investors’ environmental preferences can affect asset prices and, in turn, corporate behaviours (e.g. Pastor, Stambaugh, and Taylor, 2020). However, from an empirical perspective, identifying and studying the real impact of investors’ environmental preferences is challenging for at least two reasons. First, changes of such environmental preferences are not easily observable and measurable. Second, it is difficult to disentangle a change in environmental preferences from a change in expectations about firms’ fundamentals (cash flows and uncertainties), which are obviously also influenced by environment-related factors related, for instance, regulatory risks.
Our research (Brière and Ramelli, WP n° 117, 2021) proposes a unique way to estimate the changes in investors’ preferences for green assets that are not related to fundamental information, and to measure their impact on long-term equity returns. To do this, we evaluated arbitrage activity on the climate ETFs market i.e., the creation and redemption of shares in the ETF primary markets, which leads to observable flows in or out ETFs -- that recent work has shown to reflect nonfundamental information (Brown, Davies, and Ringgenberg, 2021; Davies, 2020).
The intuition is simple. ETFs and their underlying assets (individual stocks) have the same fundamental value, but ETFs are more prone to sentiment than underlying assets, due to their different ownership, significantly more tilted towards retail investors.1 Given these differences in ownership structure, non-fundamental demand shocks impact an ETF’s price differently from its underlying securities. When we observe violations of the law of one price between ETFs and the underlying assets (an ETF “premium”), this reveals non-fundamental demand shocks. These mispricings incentivise arbitrageurs, the Authorized Participants, to create or redeem ETF shares to correct the mispricing, creating observable ETF flows. By measuring the difference between these arbitrage flows on green and conventional ETFs, we can thus obtain an estimate of the non-fundamental demand for green assets.
Using data on a comprehensive sample of US equity ETFs from January 2010 through June 2020, we estimated for each month the differential flows into green ETFs relative to flows into conventional ETFs, net of the effects of other fund characteristics. We use the estimated abnormal flows into green ETFs to build a Green Sentiment Index, measuring the changes in investor appetite for this theme, which are not yet incorporated in the value of the underlying securities that make up these ETFs. Our green sentiment index differs significantly from other proxies of attention to climate change, such as the Google search activity on “Climate change” or the news-based climate risk indexes adopted by Engle, Giglio, Kelly, Lee, and Stroebel, 2020 (see Figure 1). These measures are likely to reflect an undefined mix of both fundamental and non-fundamental information related to climate and environmental issues.
A key result of this research is to estimate the stock price impact of green sentiment. A one-standard-deviation higher green sentiment is associated with an outperformance of the more environmentally responsible firm of approximately 30 basis points over a one-month horizon and 50 basis points over a six-month horizon, net of the effects of other firm characteristics. This impact on stock returns is large and significant, and it has the same order of magnitude than the impact of fundamental climate news, meaning that both climate risk information and changing green investors’ preferences have an impact on stock prices. Also, green sentiment has a long-lasting impact (over 6 months), with only a slight decay after that. It is particularly striking to see that this measure of sentiment derived from green ETFs flows has effects outside of the universe of stocks comprised in the ETFs baskets. There is a general appetite towards green stocks that goes beyond the particular sector of clean energy and is widely shared across markets.