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After nearly 30 years of growth and development, the field of socially responsible investing (SRI) is still poorly understood. Those of us who are practitioners in the field must, of course, shoulder some of the blame for this. But I attribute a significant amount of the misunderstanding to the transformative nature of social investing. It is difficult to fit an investment strategy that places an emphasis on social and environmental outcomes into traditional models. Although the field has become more mainstream in the past decade as large asset managers have discovered alpha in environmental, social and governance (ESG) factors, SRI still confounds and challenges.
When the Domini 400 Social Index (now known as the MSCI KLD 400 Social Index) was launched in 1990, the common wisdom said that if you limited your investable universe by anything other than financial factors, you would limit your returns. The performance of the index has proven that assumption to be false. Nevertheless, the assumption lives on.
Measuring the Cost of Socially Responsible Investing(Adam Jared Apt, Advisor Perspectives, May 21, 2013) is a case in point. The articlereviewed a 2008 paper written by Mark Kritzman and Timothy Adler that concluded, “socially responsible investing, properly understood, incurs a cost to the portfolio.”1 The core of the study rests on that phrase “properly understood.” In fact, after reading the study, it is clear that SRI is not well understood at all. The study is based on serious misconceptions about the process of social investing and its outcomes. In my view, the study has no application to SRI or the current debate over fossil-fuel divestment.
The Adler-Kritzman study used a Monte Carlo simulation to model and compare expected returns from a constrained and an unconstrained investable universe, at various levels of active-management skill. To create the constrained SRI universe, Adler and Kritzman “randomly deleted some fraction of the original universe to capture the effect of restricting a universe for purposes unrelated to expected performance. By randomly deleting observations, we assumed implicitly that good companies are no more or less likely to outperform bad companies.”2
If this assumption is false – or is only false for certain types of companies – the study falls apart. This assumption also ensures that there is no place in the study for any degree of skill in implementing social and environmental factors.
The study fails to ask the key question: How does the use of social and environmental factors to select investments affect performance? The study’s authors assume these factors have no financial relevance, apparently because certain investors that utilize them are not primarily motivated by financial considerations.
The study is therefore not designed to determine whether there is a cost to SRI. Rather, it is meant to illustrate a point the authors consider to be axiomatic. Kritzman introduced his paper to an audience at Middlebury College in January, as follows, “I know you all accept that there’s a cost [to fossil-fuel divestment], right? I’m going to tell you how you go about measuring it.”
1. Timothy Adler and Mark Kritzman, “The Cost of Socially Responsible Investing,” Journal of Portfolio Management, Fall 2008, vol. 35, no. 1, pp. 52-56.
2. Curiously, later in the study, the authors asserted that they made no such assumption: “We make no assumption about the relative performance of ‘good’ companies and ‘bad’ companies.” They did, however, by assuming these characteristics are unrelated to performance.
SRI investors do not make decisions randomly
Apt claimed that Kritzman has been misunderstood and that his critics overlook the study’s critical distinction between SRI and active management. This, however, is one of the paper’s core misconceptions – there is no distinction. All forms of social investment are forms of active management, because SRI involves a process of principled decision-making. Even passively managed SRI funds track indices that are themselves actively managed (compare, for example, the management of the MSCI KLD 400 Social Index with the Russell 3000). Truly passive SRI is a contradiction in terms.
SRI presents a challenge to traditional conceptions of active management. The study’s authors relied upon investor motivations to separate what they considered to be true active management, from SRI. Hence, Adler and Kritzman stated, “if investors are motivated to own good companies because they expect higher returns from them, they are not socially responsible investors.” The problem, of course, is that they are still socially responsible investors. The authors redefined the world outside their model, rather than changed the model to accurately reflect the world.
Take, for example, the current debate over fossil-fuel divestment. Kritzman has presented his study in a variety of venues as an accurate method to measure the expected costs of divestment. The study made no reference to the oil, gas or fossil-fuel industries. Random selection is meant to account for everything.
Fossil-fuel divestment, however, is anything but random, and the removal of all fossil fuels from a portfolio will have specific financial implications relating to the behavior of those stocks and their role within a diversified portfolio. This would be true whether the divestment was undertaken for moral reasons or financial ones. (Some investors argue that fossil-fuel companies are dramatically overvalued and at risk of collapse due to peak oil or unburnable carbon, the estimated 80% of proven fossil fuel reserves that must remain in the ground if we are to hold global temperature increases to 2 degrees Celsius.)
I may exclude tobacco companies because I’m morally opposed to their business model, or I may exclude tobacco companies because I recognize the market is shrinking for highly addictive products that offer no benefits. Either way, the risk and return characteristics of my portfolio are the same. The same can be said of every other category of exclusions or inclusions, from heavy polluters to human rights violators to nuclear power operators. Motivation does not correlate to financial results.
SRI’s value proposition
A study that purports to test the financial viability of a strategy must test that strategy – it cannot simply assume the strategy is worthless and then model it with a nullity. That is precisely what Adler and Kritzman have done, however, by using random deletion as a proxy for SRI.
The core financial performance claim for SRI is that corporate value depends upon numerous relationships, including those with employees, customers, communities and the natural environment. Companies that manage these relationships well should prosper in the long run, and those that damage them will face obstacles to their long-term success. SRI is entirely consistent – and predates – evolving notions of corporate value such as those elaborated by Michael Porter and Mark Kramer in their concept of “shared value,”3 and by the International Integrated Reporting Council, which views corporate value in the context of a range of external interdependencies. As Porter and Kramer put it, “societal needs, not just conventional economic needs, define markets, and social harms can create internal costs for firms.” Kritzman and Adler’s approach is premised on the notion that these approaches to understanding corporate value are misguided. Their study, therefore, is irrelevant to social investment, which takes these approaches to be self-evident.
Social investors are motivated by a range of factors. Some seek consistency with a set of moral precepts or personal values, and they may be willing to place these choices above financial return. Others are seeking to have a positive impact on the world through their investment decisions. Some believe that social and environmental factors provide indicators of quality management and can help to flag risks and opportunities that are otherwise overlooked. All of these investors expect their financial advisors or mutual fund managers to address these objectives while also meeting their financial goals.4
I presume that Adler and Kritzman are seeking to model costs for the first category of social investor – the investor that seeks to invest consistent with a set of moral or personal values, regardless of the financial implications.5 These investors are the least likely to place much value on Adler and Kritzman’s results, but of course, even those investors that care little for the financial value of their moral commitments deserve an accurate accounting. Adler and Kritzman’s study does not provide this accounting.
Here is where the intersection of moral and financial values creates such confusion. A company that offends societal norms to such an extent that some would find it morally repugnant to hold their stock may have done material damage to its reputation or its social license to operate, which can have financial implications. In many cases, the moral analysis can point to issues that have not yet become financially material but may in time.
This study places all such moral value judgments in one bucket, and financial value judgments in another. This is a false distinction. The study implicitly asserts that the removal of all tobacco manufacturers from a portfolio is no different than the removal of all fossil-fuel companies. It cannot address the impact of including solar-cell manufacturers while removing pesticide manufacturers and apparel companies with poor human rights records. Each of these decisions, often driven by moral concerns, carries a set of financial implications. One fails to see this by viewing the world through the distorting lens of so-called good and bad companies.
3. Michael E. Porter and Mark R. Kramer, Creating Shared Value, Harvard Business Review, January-February 2011.
4. For a helpful overview of the objectives of social investors, see Lloyd Kurtz’s chapter, “Terminology and Intention” in Krosinsky, Robins and Viederman, Evolutions in Sustainable Investing: Strategies, Funds and Thought Leadership (Wiley, John & Sons, 2011).
5. We must also assume that their portfolio managers have not utilized any strategies to address any structural imbalances to the portfolio caused by the exclusion of entire industries, sectors or otherwise profitable investments.
Adler and Kritzman ignored decades of academic literature on SRI
There are several decades of studies on the performance of SRI funds and the materiality of social and environmental factors that the authors simply ignored, preferring to rely on a hypothetical model. For example, a rigorous study of the 18-year performance history of the MSCI KLD 400 Social Index, the longest-running index subject to multiple social and environmental screens, demonstrated that “the impact of the social screens appears negligible” relative to the S&P 500. With respect to the index’s exclusion of the tobacco industry, “the cost of this policy rounds to zero.”6 A 2012 meta-study of more than 100 academic studies conducted by Deutsche Bank’s DB Climate Change Advisors found that environmental, social and governance factors are “correlated with superior risk-adjusted returns at a securities level” and that SRI funds that practice exclusionary screening do not inherently underperform. According to a 2007 meta-study conducted by the United Nations Environmental Program Financial Initiative (UNEP FI) and Mercer, “the argument that integrating ESG factors into investment analysis and decision-making will only lead to underperformance simply cannot be made.” Its 2009 follow-up study reinforced that message.7
More importantly, empirical data is necessary to test the soundness of conclusions drawn from hypothetical models. When a hypothetical model produces results that directly contradict the empirical data, it is incumbent upon the researcher to address these conflicts and adjust the model if necessary. Kritzman and Adler did not even acknowledge that there is a body of empirical data to contend with.
The costs of ignoring the real world
When assessing the costs and benefits of SRI, we must also assess the costs of failing to invest with social and environmental priorities in mind. Although difficult to quantify, these costs are quite clear. A litany of preventable surprises, including Deepwater Horizon, Fukushima and the recent disasters in Bangladesh could have been predicted and possibly prevented through more enlightened investor analysis and engagement. As the economist Albert Hirschman taught, poor performance can best be addressed through a combination of exit and voice – excluding poor performers is part of this process of effective engagement.8
The most significant challenge facing the planet, and its investors, is the carbon content of the world’s oil and gas reserves. As the New Yorker ’s Elizabeth Kolbert recently put it,
Were we to burn through all known fossil-fuel reserves, the results would be unimaginably bleak: major cities would be flooded out, a large portion of the world’s arable land would be transformed into deserts, and the oceans would be turned into liquid dead zones. If we take the future at all seriously, which is to say as a time period that someone is going to have to live in, then we need to leave a big percentage of the planet’s coal and oil and natural gas in the ground.
This assessment carries significant financial implications, which can be addressed through a variety of methods. Each will carry its own set of costs and benefits. But these strategies, if they have any hope of effecting environmental outcomes, cannot be undertaken randomly.
Adam M. Kanzer is managing director and general counsel of Domini Social Investments LLC.He would like to thank Shin Furuya, Lloyd Kurtz, Carole Laible, Steve Loren and David Wood for taking the time to provide their comments and perspectives. The final result represents the author’s views alone.
6. Lloyd Kurtz and Dan DiBartolomeo, “The Long-Term Performance of a Social Investment Universe,” The Journal of Investing, Fall 2011.
7. Mercer, Shedding Light on Responsible Investment: Approaches, Returns and Impacts (November 2009). See also additional studies cited in Kurtz andDiBartolomeo.
8. Albert O. Hirschman, Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States (Cambridge, MA: Harvard University Press, 1970)
Read more articles by Adam M. Kanzer
