Divestments can be an important tool in the transition to a more sustainable world since they send a clear signal that markets and investors no longer tolerate companies falling short on environmental, social and governance goals, a recent study has found. Pulling your money out may affect returns, but to create change and hopefully improve environmental and social issues, investment managers should both divest and engage.
This article is part of our series on current academic research into a range of sustainability-related investment topics. It is based on one of two winning papers presented to the Global Research Alliance for Sustainable Investment and Finance at the latest GRASFI conference. We believe in science-led sustainable investment. Partnering with academic researchers can add value in that it helps us grasp the scope of climate change and biodiversity loss, quantify risk, and develop fit-for-purpose solutions. Therefore, we sponsor the annual GRASFI conference and share relevant scientific findings with investors, clients and the wider asset management industry on our websites.
In the drive to make investments more sustainable, the effectiveness of divestment as a tool for fund managers and investors to align poor performers with ESG goals is a topic of debate. It can be an alternative to engagement, but what is its impact on the divested companies?
Selling off holdings to financially constrain firms with poor ESG behaviour can be a catalyst for positive change. An alternative is engagement, whereby firms and shareholders interact with investee companies’ management to encourage more sustainable behaviour. This partly relies on the idea that divestment does not impact the divested firms because there will always be someone else who will pick up the divested stock.
The authors  of the GRASFI 2023 Best Paper Award-winning paper, “The effect of divestment from ESG Exchange-Traded Funds”, investigated whether divestment can contribute to enacting change by affecting companies’ share prices and cost of capital.
By tracking changes in ESG ETF quarterly holdings, they contribute a new method of identifying divestment events from (mainly passive) funds. The study shows that divestment can have a prolonged and significant negative effect on stock returns. It can increase the cost of capital and – through stakeholder awareness of public divestments – affect future cashflows and increase reputational risks.
In the current economic and social climate, ESG investing is becoming an accepted approach for many asset managers, who are motivated predominantly by the demand of their clients as well as the material risks and opportunities of ESG issues.
Divesting – The strong-arm approach
ESG ETFs can provide retail investors with highly liquid, low-cost and diversified investment options. The managers of such funds exercise discretionary power on behalf of their clients concerning asset allocation and voting decisions, including those relating to climate risks/opportunities.
Divestment can be seen as a ‘strong-arm’ approach that may ultimately force the firm to change if it wants to continue to access favourable financing. For divestment to be effective in creating change in a firm, the negative effect needs to be prolonged, so that access to, and the cost of capital are impacted and the firm has to enact change to attract investors.
Analysing the holdings of 176 ETFs, the study identifies 45 397 unique divestments within a sample of 12 071 firms. It finds that the greater the number of ESG ETFs divesting from a firm (in effect, proxying for coordinated divestment) the more negative the future stock returns over a period of at least five quarters following the divestments.
The end goal of divestment campaigns based on ESG is that the target firm should become more socially responsible. A divestment trend can lead to reduced demand for shares and bonds, which increases the cost of capital for the target firm, in turn making it more difficult to finance projects. This drives the firm to adjust to reduce its level of harm or improve its behaviour.
The study shows that for each additional ESG ETF that divests from a firm, on average its stock returns are 1.14% and 0.25% lower in the following two quarters. There is also a significant increase in the cost of capital for a divested firm one quarter after divestment, followed by a much stronger negative relationship to the weighted-average cost of capital (WACC) five quarters later. This effect becomes more pronounced when the divestment is more coordinated.
The study focused primarily on cases where the holding of the ESG ETF in the firm goes to zero. If a large proportion of fund managers opt for slow divestment – reducing the holding value by less than 20% per quarter – it would bias against the study’s results, meaning the real effect of divestment is likely even larger than this research shows.
Both divest and engage
The study’s authors concluded that, to create change in firms and hopefully improve the world’s environmental and social conditions, investment managers need to both divest and engage, as both approaches affect firm value and actions.
Neither one nor the other is better, but they are more appropriate in different situations. Engagement should not be used as a reason to stay invested in firms unwilling to change, but rather to work with firms willing and able to change, while divesting from firms unwilling to avoid material and significant climate impacts.
For both approaches, the study argues that coordination/collaboration will make the desired outcome more likely as the pressure on the companies is amplified.
“This study makes a notable contribution to the debate around the theory of change behind sustainable finance. From the results, it is clear that divestment can be an important tool in effecting change in corporate practices and ipso facto the real economy. When used assiduously, especially in conjunction with ESG integration and collaborative engagement strategies, it can help sustainable investors to realise their desired outcomes.” – Alex Bernhardt, Global Head of Sustainability Research, BNP Paribas Asset Management