Swedroe: Principle Over Profits

March 30, 2018

Socially responsible investing (SRI) has gained a lot of traction in portfolio management in recent years. In 2016, socially responsible funds managed about $9 trillion in assets from an overall investment pool of $40 trillion in the United States, according to data from US SIF.

While SRI, as well as the broader category of environmental, social and governance investing, continues to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower P/E ratio, thus offering higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to offensive companies).

Research On Socially Responsible Investing

Arno Riedl and Paul Smeets contribute to the literature on socially responsible funds with their study “Why Do Investors Hold Socially Responsible Mutual Funds?”, which appears in the December 2017 issue of The Journal of Finance. In it, they sought to determine why investors choose to hold socially responsible mutual funds.

They note: “While it is tempting to conclude that strong pro-social preferences drive this decision, other motives are also possible. On the financial side, investors may have optimistic risk-return expectations for SRI or a desire to diversify their portfolio risk. Another possible motive could be that investors hold SRI to boost their social image or reputation.”

To find answers, Riedl and Smeets obtained administrative data (on 3,382 investors) from a large mutual fund provider that offers a wide variety of socially responsible and conventional mutual funds. Individual investors buy and sell the funds directly online without the interference of an intermediary.

The authors then merged the data with results from a survey, and incentivized experiments they conducted using a large group of individual investors, creating a unique data set that links the administrative data of conventional and socially responsible investors to their behavior in controlled experiments and to answers in a comprehensive survey.

To obtain a clean measure of social preference, they created a two-player trust game in which the first mover can transfer money to the second mover. The transferred amount is tripled by the experimenter. The second mover can send back to the first mover all, part or none of the money received. The behavior of the first mover mainly captures trust, which is why this is called a trust game. Because Riedl and Smeets wanted to capture social preferences rather than trust, they use the behavior of investors in the role of second movers to measure intrinsic social preferences.

The authors write: “A second mover who behaves like the prototypical homo economicus should not send back any money. The more an investor in the role of second mover returns, the stronger are the investor’s intrinsic social preferences.”

 

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