The Folly of Institutions Dumping Fossil Fuel Stocks From Their Portfolio

A few weeks ago, Larry Swedroe wrote an interesting piece on the costs of ‘socially responsible investing.’  According to Swedroe, investors who shun stocks or industries for environmental, social, and other reasons are likely to suffer “reduced risk adjusted returns and less efficient diversification.”  This warning from Larry seems especially timely given the growing call from many activist groups for pension funds and other institutional investors to dump fossil fuel stocks from their portfolios.

Pointing to the recent carnage in oil and gas stocks, groups such as the University of Utah faculty and the California Democratic Party have suggested that it is both in the environmental and financial best interests of their funds to divest assets tied to fossil fuels.  However well-intentioned this desire may be, a longer view than just the last few years reveals that this would likely be a costly mistake for already cash-strapped pension plans.

Consider that going back to 1926 (through 2015), the energy sector as a whole has been one of the strongest and most consistent performers of the overall US stock market*:

(source:  Ken French)

Since 1974, the energy sector as a whole has performed slightly better than the S&P 500 (11.08% vs 10.85% annually), but energy stocks have been proven to be good diversifiers as returns have shown little correlation with the overall market:

fossil fuel stocks
fossil fuel stocks

This is in stark contrast to the technology and financial sectors, that have much higher correlations with the overall market.

Another way to illustrate the benefit of owning energy stocks is to take a closer look at the oil sector (the major component of the energy sector).  The oil sector has tended to perform better when the overall market (as gauged by the S&P 500) has been weak (shaded areas):

(sources:  Ken French; Morningstar)

Finally, those who think that recent weakness in oil and gas stocks is signalling the demise of the industry may be misinterpreting the tea leaves by ignoring the impact of movements in the dollar (i.e. a weak dollar is bullish for oil and oil stocks, and vice-versa).  In fact, weakness in the oil sector versus the overall market has almost always coincided with strength in the US dollar:

(Sources:  Ken French; Morningstar; Federal Reserve)

So, in sum, investors eager to divest their portfolios of fossil-fuel related stocks may be setting themselves up for a shock the next time the dollar cycle turns down, or their portfolio of tech and financial stocks take a tumble with the overall market as inflation pushes oil and gas prices higher.

The information provided above is obtained from publicly available sources and it is believed to be reliable. However, no representation or warranty is made as to its accuracy or completeness.