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.”

 

Study Results

Following is a summary of their findings:

  • About 16% of the investors in the sample can be classified as socially responsible investors, holding at least one SRI equity fund.
  • Socially responsible investors are more likely than conventional investors to hold a university degree (59% versus 47%).
  • The strongest and most robust result is that intrinsic social preferences play an important role in determining socially responsible investment. In their experiment, an investor who equally shares in the trust game was 14 percentage points more likely to hold an SRI equity fund compared to a “selfish” investor who keeps all the money.
  • Strong social preferences are required to purchase an SRI fund in the first place, but they are less important for choosing the fraction of the portfolio to allocate to SRI funds once this first hurdle has been overcome. However, in line with the social signaling hypothesis, investors with weak social preferences who strongly signal their investment behavior hold significantly smaller portions of socially responsible investments. This suggests that relatively “selfish” investors who hold socially responsible investments for signaling reasons minimize the percentage they hold.
  • Social signaling motivates investors’ SRI equity fund holdings; investors who talk more often about their investments are more likely to invest in a socially responsible way.
  • Socially responsible investors donate about 41% more to charity than conventional investors, implying that SRI is not a substitute for charitable giving.
  • Investors are willing to pay significantly higher management fees on SRI funds than on conventional funds.
  • A majority of investors expect SRI funds to underperform relative to conventional funds, with only 17% and 15% of socially responsible and conventional investors, respectively, expecting higher returns on SRI funds than on conventional funds. On the other hand, 49% of socially responsible investors and 56% of conventional investors expect to earn equal or a bit lower returns on SRI funds than on conventional funds.
  • Investors who expect SRI equity funds to underperform relative to conventional equity funds are less likely to invest in a socially responsible manner, indicating some investors are willing to forgo financial performance to invest in mutual funds that are in concordance with their social preferences. At the margin, pessimistic performance expectations reduce the likelihood of investing in a socially responsible way.
  • Risk perceptions are unrelated to SRI fund holdings.
  • Individual socioeconomic characteristics only play a marginal role in determining whether investors hold SRI equity funds.
  • Only 5% of all socially responsible investors indicate they hold SRI funds to pursue diversification benefits.

Riedl and Smeets also found that socially responsible investors realized significantly lower mean returns and worse Sharpe ratios on the SRI part of their equity portfolio over all three horizons they considered, and that the average yearly total expense ratio is significantly higher for socially responsible equity funds than for conventional equity funds.

Thus, they concluded: “Taken together the … results indicate that financial motives are unlikely to be the main driver behind SRI.”

Summary

Riedl and Smeets found that most socially responsible investors expect SRI funds to earn lower returns than conventional funds, to achieve worse Sharpe ratios and to pay higher fees.

They explain: “These findings suggest that on average investors with a strong social motivation are willing to forgo financial returns in order to invest in accordance with their social preferences. Social preferences and—to some extent—social signaling are important for SRI decisions. The effect of social preferences is likely to be particularly long lasting, as SRI has been steadily rising in recent years.”

Investors should also be aware that, over time, socially responsible investors’ impact on asset prices could increase as their preferences drive up the stock prices of socially responsible companies and drive down the stock prices of “sin” companies. In other words, expressing one’s preferences could have a negative impact on investment performance, which could be considered a price socially responsible investors are willing to pay in exchange for expressing their views through their investment choices.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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