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.
Greg Richey studied the “price of sin” in his January 2017 paper, “Fewer Reasons to Sin: A Five-Factor Investigation of Vice Stocks.” His study covered the period from October 1996 to October 2016. Richey employed the single-factor Capital Asset Pricing Model (market beta), the Fama-French three-factor model (adding size and value), the Carhart four-factor model (adding momentum) and the new Fama-French five-factor model (market beta, size, value, profitability and investment) to investigate whether a portfolio of vice stocks outperformed the S&P 500 Index, a benchmark to approximate the market portfolio, on a risk-adjusted basis. His data set included 61 corporations from vice-related industries. The following is a summary of his findings:
- For the period from October 1996 through October 2016, the S&P 500 returned 7.8% per year. The “Vice Fund” returned 11.5%.
- The alpha, or abnormal risk-adjusted return, showed a positively significant coefficient in the CAPM, Fama-French three-factor and Carhart four-factor models.
- All models, including the Fama-French five-factor model, indicated that the Vice Fund portfolio beta was between 0.59 and 0.74, indicating that it had less market risk or volatility than the S&P 500 Index, which has a beta of 1, over the sample period. This reinforces the defensive nature of sin portfolios. With the three- and four-factor models, the vice portfolio had a statistically significant negative loading on the size factor (-0.17 and -0.18, respectively) and a statistically positive loading on the value factor (0.15 and 0.21, respectively), indicating that these exposures help explain returns. With the four-factor model, the Vice Fund loaded about 0.11 on momentum, and it was statistically significant. However, with the five-factor model, the negative size loading shrank to just -0.05 and the value loading turned slightly negative, also at -0.05, and both are statistically significant. In the five-factor model, the vice portfolio loaded strongly on both profitability (0.51) and investment (0.48). All of the figures are significant at the 1% level.
- The annual alphas on the CAPM, three-factor and four-factor models were 2.9%, 2.8% and 2.5%, respectively. All were significant at the 1% level. These findings suggest that vice stocks outperformed on a risk-adjusted basis. However, in the five-factor model, the alpha virtually disappeared, falling to just 0.1% per year. This result helps explain the performance of vice stocks relative to the market portfolio that previous models failed to capture. The R-squared figures ranged from about 0.5 to about 0.6. Richey concluded that the higher returns to vice stocks were because those corporations’ investments were more profitable and less wasteful than the average corporation.
Richey’s findings are consistent with other studies on sin stocks.
Harrison Hong and Marcin Kacperczyk also found that sin and vice stocks have outperformed. Their study “The Price of Sin: The Effects of Social Norms on Markets,” published in the July 2009 issue of the Journal of Financial Economics, found that for the period from 1965 through 2006, a U.S. portfolio long sin stocks and short non-sin stocks had a return of 0.29% per month after adjusting for the four-factor model. As out-of-sample support for their findings, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5 percentage points per year. They concluded that the abnormal risk-adjusted returns of vice stocks are due to neglect by institutional investors, who lean on the side of SRI. I provided a more detailed analysis of this study in a February 2016 article for Advisor Perspectives, Sustainable and Responsible Investing: Is There a Price to Pay? The article also provided a risk-based analysis of socially responsible funds.
As further evidence that avoiding sin stocks comes at a price, Elroy Dimson, Paul Marsh and Mike Staunton in their article “Industries: Their Rise and Fall,” which was published in the Credit Suisse Global Investment Returns Yearbook 2015, found that, when using their own industry indices that covered the 115-year period from 1900 through 2014, tobacco companies beat the overall equity market by an annualized 4.5 percentage points in the U.S. and by 2.6 percentage points in the U.K. (over the slightly shorter 85-year period from 1920 through 2014).
They also examined the impact of screening out countries based on their degree of corruption. Countries were evaluated using the Worldwide Governance Indicators from a 2010 World Bank policy research working paper by Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues.” The indicators comprised annual scores on six broad dimensions of governance.
Dimson, Marsh and Staunton found that 14 countries posted a poor score, 12 were acceptable, 12 were good and 11 were excellent. Post-2000 returns for the last three groups were between 5.3% and 7.7%. In contrast, the markets with poor control of corruption had an average return of 11.0%.
Interestingly, realized returns were higher for equity investments in jurisdictions that were more likely to be characterized by corrupt behaviors. As the authors noted, the time period is short and the result might just be a lucky outcome. On the other hand, it’s also logical to consider that investors will demand a premium for taking corruption risk. But it may also be a result of the same exclusionary factors found with sin stocks (investors boycott countries with high corruption scores, driving prices down, raising expected returns).
Development of a socially responsible factor model
Meir Statman and Denys Glushkov’s study, Classifying and Measuring the Performance of Socially Responsible Mutual Funds, was published in the winter 2016 issue of The Journal of Portfolio Management. They added two social responsibility factors to the commonly used four-factor model (beta, size, value and momentum).
The first social responsibility factor they proposed is the top-minus-bottom factor (TMB), consisting of employee and community relations, environmental protection, diversity and products. The second factor was the accepted-minus-shunned factor (AMS), which is the difference between the returns of stocks of companies commonly accepted by socially responsible investors and the returns of stocks of companies commonly shunned. Shunned stocks included those of companies in the alcohol, tobacco, gambling, firearms, military and nuclear industries.
Statman and Glushkov built their social responsibility factors with data from the MSCI ESG KLD Stats database and noted, “The two social responsibility factor betas capture well are the social responsibility features of indices and mutual funds. For example, TMB and AMS betas are higher in the socially responsible KLD 400 Index than in the conventional S&P 500 Index.”
The authors’ study covered the period from January 1992 (when data first became available) through June 2012. To construct their two social responsibility factors, they calculated each company’s TMB-related score (total strengths minus total concerns) at the end of each year based on their set of five social responsibility criteria (employee relations, community relations, environmental protection, diversity and products) and its AMS-related score, based on whether it is “shunned” or accepted. They then matched the year-end scores with returns in the subsequent 12 months.
The long side of the TMB factor is a value-weighted portfolio of stocks from firms that ranked in the top third of companies sorted by industry-adjusted net scores in at least two of their five social responsibility criteria and not in the bottom third by any criterion. The short side of the TMB factor is a value-weighted portfolio of stocks from firms ranked in the bottom third of companies sorted by industry-adjusted net scores in at least two of the five social responsibility criteria and not in the top third by any criterion.
Similarly, the long side of the AMS factor was a value-weighted portfolio of the accepted companies’ stocks, and its short side was a value-weighted portfolio of shunned companies' stocks. The authors constructed the TMB and AMS portfolios at of the end of each year. The following is a summary of their findings:
- On average, the returns of the top social responsibility stocks exceeded those of the bottom social responsibility stocks. The TMB factor's mean annualized return was 2.8%.
- On average, the returns of accepted stocks were lower than the returns of shunned stocks. The AMS factor’s mean annualized return was -1.7%.
- There was virtually no correlation of returns between the two factors.
- The six-factor alpha for the TMB factor was 0.55%, implying that social responsibility improves performance when it’s in the form of high TMB. The incremental alpha due to high TMB was generally statistically significant.
- The six-factor alpha for the AMS factor was -0.36%, implying that social responsibility detracted from performance when it’s in the form of high AMS. The negative alpha could be viewed as the price of avoiding “sin” stocks. However, the AMS score was not statistically significant.
- The difference in alpha is most pronounced when comparing funds with high TMB and low AMS betas to funds with low TMB and high AMS betas. The first group has high alpha and the second has low alpha. The difference in annualized alphas was a statistically significant 0.91%.
Statman and Glushkov concluded: “A lack of statistically significant differences between the performances of socially responsible and conventional mutual funds is likely the outcome of socially responsible investors’ preference for stocks of companies with high TMB and high AMS. The first preference adds to their performance, whereas the second detracts from it, such that the sum of the two is small. A proper analysis of socially responsible mutual funds’ performance requires separate accounting for the effects of TMB and AMS on performance.”
Their finding that the AMS factor produced negative alpha is consistent with both the theory I mentioned previously and prior research. The finding of positive alpha for the TMB factor, however, is a puzzle for the same reason that the negative alpha for AMS would be expected. If enough SRI investors shun stocks with low TMB scores, the cost of capital of such companies will rise, and so will their expected returns. Hence, the apparent anomaly. Perhaps the positive alpha is explained by exposure to another factor (such as quality or low beta) not included in the four-factor model (beta, size, value and momentum). The research provides us with other possible explanations:
- The 2005 study “The Eco-Efficiency Premium Puzzle” by Jeroen Derwall, Nadja Guenster, Rob Bauer and Kees Koedijk, found that stocks of companies with good environmental records earned higher returns than other stocks.
In each case, higher returns could result from investor myopia – they tended to focus on possible negative short-term costs (such as higher wages) and underestimated long-term benefits.
There are many forms of SRI and ESG investing. Every investor has his or her personal views. Thus, it’s no surprise that each SRI/ESG fund has its own construction methodology. For example, consider the “gay benefits” issue. Some funds exclude companies like Walt Disney for having gay-friendly policies. On the other hand, the Meyers Pride Value Fund only invests in companies with gay-partner benefits and policies that prohibit discrimination against homosexuals. There are even funds designed for Catholics (Ave Maria Mutual Funds), Muslims (Amana Mutual Funds Trust), Presbyterians (New Covenant Funds) and Christians of all faiths (the Timothy Plan). Our capitalist system is great at responding to demand.
The above evidence, supported by the experience of the Norwegian sovereign wealth fund, argues that ESG, or religiously-oriented investors, pay a price in the form of lower returns. The reason is that some screens, like those that eliminate sin stocks, lead to lower returns.
On the other hand, there are other screens that provide exposure to factors that lead to higher returns.
Carefully evaluate the construction methodology before investing in a SRI or ESG fund. It may be difficult to find a fund that exactly meets your personal criteria. For those investors with sufficiently large investable assets (e.g., $1 million in equities), certain asset managers (such as Parametric and Aperio) will build individually tailored portfolios (which may provide the added benefit of tax efficiency).
Investors who are aware of the cost of SRI/ESG investing may be willing to sacrifice higher expected returns for the expressed and emotional benefits of avoiding the stocks of shunned companies.
An alternative to SRI/ESG funds is to invest without consideration of these issues and donate the higher expected return directly to one’s most important causes.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.
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