Socially responsible investing (SRI) has captured nearly a quarter of U.S.-based assets. New evidence from one of the world’s largest sovereign wealth funds shows that those investors are sacrificing significant performance. Indeed, those clients are giving up more than 1% a year – effectively doubling the typical 1% AUM advisory fee.

Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing; investors seek profitable investments that meet their personal standards. For instance, some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages, weapons, or rely on animal testing in research and development. Other investors may also be concerned about environmental, social, governance (ESG) or religious issues. SRI and the broader category of ESG encompass many personal beliefs and don’t reflect just one set of values.

SRI has gained a lot of assets in recent years. In 2016, socially responsible funds managed approximately $9 trillion in assets from an overall investment pool of $40 trillion in the United States, according to data from the US SIF Foundation. While SRI and ESG investing continue to grow in popularity, economic theory suggests that if a large enough proportion of investors choose to avoid “sin” businesses, their share prices will be depressed. They will have a higher cost of capital because they will trade at a lower P/E ratio, thus providing investors with higher returns (which some investors may view as compensation for the emotional “cost” of exposure to offensive companies).

One of the largest SRI investors is Norway’s Government Pension Fund, the country’s sovereign wealth fund. The $870 billion fund excludes two types of companies from its investment portfolio. Product-based exclusions include weapons, thermal coal and tobacco producers and suppliers. Conduct-based exclusions include companies with a track record of human rights violations, severe environmental damage and corruption. According to Norges Bank Investment Management, which manages the sovereign wealth fund’s assets, the fund has missed out on 1.1 percentage points of additional gain due to the exclusion of stocks on ethical grounds over the past 11 years. The fund’s benchmark was the FTSE Global All-Cap index.

According to the report, product-based exclusions had the following impact:

  • The exclusions of tobacco companies and weapon manufacturers reduced the return of the equity portfolio by 1.9 percentage points.
  • Divesting from tobacco manufacturers reduced the portfolio return by 1.16 percentage points.
  • Avoiding weapons makers decreased the return by 0.75 percentage points.
  • Exclusions of mining companies had a minor effect on the return.

Findings such as these have led to the development of an investment strategy that focuses on the violation of social norms in the form of “vice investing” or “sin investing.” This strategy creates a portfolio of firms from industries that are typically screened out by SRI funds, pension funds and investment managers. Vice investors focus primarily on the “sin triumvirate”: tobacco, alcohol and gaming (gambling) stocks. The historical evidence on the performance of these stocks supports the strategy.