Does Excluding Sin Stocks Cost Performance?

Abstract

We examine the impact of excluding sin stocks on expected portfolio risk and return. Exclusions involve risk relative to the market and peers. We show how this tracking error can be translated into an equivalent loss in expected return, which is negligible at low tracking error levels, but not at higher levels. However, even modest ex ante tracking error levels may lead to sizable compounded underperformance ex post. Taking an asset pricing perspective we find that popular exclusions typically go against rewarded factors such as value, profitability, and low-risk, which is harmful for expected portfolio returns. Theoretically sin itself may also be a priced factor, but this is not supported by the empirical evidence. A sin premium might arise in the future though, if exclusion policies reach the scale needed to significantly raise the cost of capital of sin stocks. Tracking error may be minimized and expected portfolio return restored by filling the gap left by excluding sin stocks with non-sin stocks that offer the best hedging properties and similar or better factor exposures.

Keywords: Sin Stocks, Exclusion, Divestment, Environmental Social and Governance (ESG), Socially Responsible Investing (SRI), Sustainable Development Goals (SDGs), Carbon Intensity, Paris-Aligned Investing, Climate Risk, Sustainable investing, Asset Pricing, Factor Investing

JEL Classification: G11, G12, G14