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Want to stay on top of cutting-edge finance research from Wharton? Every two months, the Rodney White Center highlights the latest studies by Wharton’s finance faculty. In this issue: sizing up ESG investing and post-COVID stimulus measures; the robustness of the factor zoo; the macroeconomics of trade credits; and optimal monetary policy during financial instability.

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Itamar Drechsler and Luke Taylor

How much ESG investing is there, really?

“Investing based on environmental, social, and governance (ESG) criteria has exploded in popularity, reaching $35 trillion in global assets under management in 2020, according to Bloomberg Intelligence.” Claims like these are common, but are they accurate? To answer this question, Professors Robert Stambaugh and Lucian Taylor measure financial institutions’ portfolio tilts related to stocks’ ESG characteristics. ESG-related tilts amount to 6% of the investment industry’s AUM in 2021. By this measure, there is much less ESG investing than commonly reported. Since 2012, the investment industry has tilted increasingly toward green stocks, due to only the largest institutions. Other institutions and households tilt increasingly toward brown stocks.

How effective were post-COVID stimulus measures?

While the unprecedented fiscal and monetary stimulus following the COVID-19 outbreak paved the way for a quick economic recovery, the recent spike in inflation has called for a careful reevaluation of the long-term impacts of these measures. Professors William Diamond and Tim Landvoigt introduce a New Keynesian framework to assess the interventions from the federal government and the Federal Reserve. These policy efforts halved the decline in consumption, staved off deflation and a wave of mortgage defaults, and prevented a drop in house prices. High inflation greatly diminished the real value of nominal liabilities. Mortgage borrowers and the government were thus the main beneficiaries from high inflation. 

Exploring the “factor zoo”: The robustness of stock return anomalies

During the last five decades, economists have discovered a very large number of stock return anomalies, commonly referred to as the “factor zoo.” Professor Jules van Binsbergen finds that these anomalies are quite sensitive to the definition of excess return. Traditionally, excess return is defined as stock return minus the return on a short-duration riskless asset. Instead, Professor van Binsbergen computes returns in excess of a duration-matched government bond strategy. Had this measure been used instead, the asset pricing literature would entertain a very different set of anomalies today. Of 153 anomalies discovered to date, only 66 are robust under this new measure, while 20 can be classified as false positives or false negatives. 

Trade credits: A double-edged sword 

In the modern economy, suppliers of intermediate goods and services are essential providers of short-term financing to firms, supplying liquidity by providing clients with extended payment terms – a financial link commonly described as a “trade credit.” Professor Gideon Bornstein provides a macroeconomic framework that incorporates both traditional financing methods, like banks, and trade credits. In the model, both mechanisms differ in their incentives for repayment, with trade credits being enforced through complex reputation mechanisms rather than by law. Overall, while trade credits reduce economic distortions, they can also leave the economy more vulnerable to financial disruptions. When applied to Italian data, the model implies that trade credits exacerbated the output costs of the Great Recession by a staggering 45%.

How should interest rates react to financial instability?

Central banks have traditionally followed a Taylor rule, linking policy rates to inflation and the output gap. The Fed has deviated from this rule after recent recessions, though, increasing rates only reluctantly and very slowly. The Fed has been especially wary of increasing rates when corporate credit spreads are high, suggesting that the Fed has become less willing to target inflation when financial markets are in distress. Professor Joao Gomes and Ph.D. student Sergey Sarkisyan show that these deviations from a simple Taylor rule are welfare-improving as they mitigate the impact of corporate or banking default shocks. These results help explain Fed’s behavior after recent recessions and caution against aggressive inflation targeting in times of financial distress, such as after the SVB collapse.

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