Swedroe: Sin’s Great For Returns

November 03, 2017

Socially responsible investing (SRI) has been referred to as “double bottom line” investing, meaning investments should not only be profitable, they should meet personal standards.

For instance, some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages or weapons, or that rely on animal testing in their research and development efforts.

Other investors may also be concerned about environmental, social and 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 significant traction in portfolio management in recent years. In 2016, SRI funds managed approximately $9 trillion in assets from an overall investment pool of $40 trillion in the United States, according to data from US SIF.

While SRI and ESG investing continue to gain in popularity, economic theory suggests that if a large enough proportion of investors choose to avoid “sin” businesses, their share prices will be depressed.

In equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium on the screened assets. Screened assets will have a higher cost of capital because they will trade at a lower price-to-earnings (P/E) ratio. Thus, they provide investors with higher forward-looking return expectations (which some investors may view as compensation for the emotional “cost” of exposure to offensive companies).

Demand For SRI

Rocco Ciciretti, Ambrogio Dalo and Lammertjan Dam contribute to the SRI literature with their June 2017 study, “The Price of Taste for Socially Responsible Investment.” They begin by observing that the demand for SRI can be explained by two different effects: the favorable risk characteristics of “responsible” assets and investors’ taste for such assets.

They write: “The risk effect arises when responsible assets exhibit financial risk characteristics that appeal to investors. For example, SRI might reduce exposure to stakeholder risk, such as potential consumer boycotts or environmental scandals, that have an impact on stock returns.”

Their explanation for the taste effect “is that certain investors do not want to facilitate ‘irresponsible’ corporate conduct and construct their portfolios accordingly.”

The authors then focus their paper on the taste effect’s contribution in risk-adjusted returns—in other words, the “the price of taste.”

To determine the price of taste, Ciciretti, Dalo and Dam built a model that accounts for exposure to the market beta, size, value and momentum factors, as well as incorporating an SRI score based on six dimensions: business behavior, corporate governance, community involvement, environment, human resources and human rights. Their study covers the period July 2005 through June 2014 and 1,000 firms (295 in the U.S., 512 in Europe and 193 in the Asia-Pacific region).

Following is a summary of their findings:

  • Overall, the average monthly excess return declines moving from the worst to the best SRI portfolio.
  • A strategy that buys the worst portfolio and sells the best portfolio yields an additional excess return of 7.2 percentage points on annual basis, and was statistically significant (t-stat of 4.0).
  • Composing portfolios with firms that have higher responsibility scores does not increase the overall portfolio market beta, value or momentum exposures. However, the size and corporate social responsibility (CSR) risk factor betas decrease moving from the worst to the best SRI portfolios—companies become larger and SRI scores become better (decreasing stakeholder risk exposure for firms with higher social responsibility scores).
  • There’s a significant and negative relationship between social responsibility scores and risk-adjusted returns, with price of taste amounting to 4.8% annually for the representative responsible firm.

The authors concluded: “Both risk and taste play a role in explaining differences in returns between more and less responsible companies.”

They added that investors pay a price in terms of lower returns due to their preference for SRI, and also that the premium related to the responsibility score, the price of taste, is negative and significant. These findings are consistent with prior research.

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