Is the ESG market more volatile?

Introduction

Environmental, social, and governance (ESG) investing has become an increasingly popular way for investors to align their values with their financial goals. ESG investing involves considering a company’s environmental, social, and governance practices when making investment decisions. This type of investing has gained traction in recent years as investors have become more aware of the impact their investments can have on the world around them.

ESG investing has become particularly important in today’s investment landscape as concerns about climate change, social inequality, and corporate governance have risen to the forefront of public discourse. Companies that prioritise sustainability, social responsibility, and good governance are increasingly seen as more attractive investment opportunities, as they are better equipped to navigate the challenges and opportunities of a rapidly changing world.

As a result, ESG investing has grown in popularity, with more and more investors looking for ways to incorporate these principles into their portfolio. According to a report from the Global Sustainable Investment Alliance, sustainable investment assets under management grew by 34% from 2016 to 2018, with an estimated $30.7 trillion in assets under management globally. This trend is likely to continue as investors seek out investments that align with their values and provide long-term financial returns.

What is volatility?

Volatility is a measure of the amount of risk or uncertainty associated with an investment. It is often used to describe the fluctuations in the price of a security or market index over time. In general, investments with higher volatility experience wider price swings, both up and down, compared to investments with lower volatility.

There are several ways to measure volatility, but two of the most commonly used methods are standard deviation and beta.

Standard deviation is a statistical measure that reflects the amount of historical price variation for a particular security or market index. A higher standard deviation indicates a higher level of volatility, while a lower standard deviation indicates a lower level of volatility.

Beta is a measure of a security’s or market index’s volatility in relation to the overall market. A beta of 1.0 means that the security or index is expected to move in line with the market, while a beta of less than 1.0 indicates lower volatility than the market, and a beta of greater than 1.0 indicates higher volatility than the market.

Both standard deviation and beta can be useful tools for assessing the level of risk associated with an investment, and can help investors make informed decisions about how to allocate their assets. However, it’s important to note that volatility is not the only factor to consider when making investment decisions, and it should be just one part of a comprehensive investment strategy.

Volatility in the ESG market:

There is evidence that ESG stocks tend to be more volatile than traditional stocks. For example, a study published in the Journal of Banking and Finance found that the volatility of ESG stocks was significantly higher than that of traditional stocks, as measured by standard deviation. Another study published in the Journal of Sustainable Finance and Investment found that the beta of ESG stocks was significantly higher than that of traditional stocks, indicating a higher level of volatility relative to the overall market.

There are several possible reasons for the higher volatility of ESG stocks. One reason may be the lack of liquidity in the ESG market. Because the market for ESG investments is still relatively small compared to the overall market, there may be fewer buyers and sellers of ESG stocks, which can lead to wider price fluctuations.

Another possible reason for the higher volatility of ESG stocks is the smaller size of many ESG companies. Smaller companies tend to be more susceptible to changes in market conditions, which can lead to higher levels of volatility.

Implications of volatility for ESG investors:

The higher volatility of ESG stocks can have significant implications for investors. On the one hand, the higher volatility means that ESG investments carry a higher level of risk compared to traditional investments. This means that investors could experience wider price swings and potentially larger losses in the short-term.

However, the higher volatility of ESG stocks also means that there is the potential for higher returns in the long-term. While it’s difficult to predict exactly how any particular investment will perform, the higher volatility of ESG stocks may present opportunities for investors to capitalize on price movements and potentially earn higher returns.

Given the higher risk and potential for higher returns associated with ESG investing, it’s important for investors to carefully consider their investment strategy and risk tolerance. Diversification is particularly important for ESG investors, as it can help spread risk across a wider range of investments and potentially mitigate the impact of any individual investment’s volatility.

Risk management is also crucial for ESG investors. This may involve setting appropriate limits on the amount of risk an investor is willing to take on, as well as regularly reviewing and adjusting the portfolio to ensure that it remains aligned with the investor’s goals and risk tolerance.

Conclusion:

In this blog post, we explored the concept of volatility and its implications for investors in the ESG market. We saw that evidence suggests that ESG stocks tend to be more volatile than traditional stocks, as measured by standard deviation and beta. This higher volatility is likely due to a combination of factors, including the lack of liquidity in the ESG market, the smaller size of many ESG companies, and the greater uncertainty surrounding these investments.

We also discussed the implications of this higher volatility for ESG investors. On the one hand, the higher risk associated with ESG investing means that investors could experience wider price swings and potentially larger losses in the short-term. However, the higher volatility also presents opportunities for higher returns in the long-term.

Given the higher risk and potential for higher returns associated with ESG investing, it’s important for investors to carefully consider their investment strategy and risk tolerance. Diversification and risk management are key to maximizing the potential rewards of ESG investing while minimizing the risks.

Looking to the future, the outlook for ESG investing and volatility remains positive. As concerns about climate change, social inequality, and corporate governance continue to rise, more and more investors are seeking out investments that align with their values and provide long-term financial returns. This trend is likely to continue, and we can expect to see growth in the ESG market and potentially higher volatility as well.

Gibran Registe-Charles is ESG Director and CEO and Founder of Urban Edge Capital an ESG Diversity and Inclusion hedge fund