Swedroe: When Vice Outperforms Virtue

March 03, 2017

Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that investors are seeking not only profitable investments, but investments that meet their personal standards.

For instance, some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages or weapons, or rely on animal testing as part of their research and development efforts. Other investors may also be concerned about environmental, social, governance (ESG) or religious issues. It is important to note that 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 traction in portfolio management 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 US SIF.

While SRI and ESG investing continue to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the 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).

The Other Side Of The Coin

Thus, an investment strategy that focuses on the violation of social norms has developed 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 theory.

Greg Richey provides the latest contribution to the literature on the “price of sin” with his January 2017 paper, “Fewer Reasons to Sin: A Five-Factor Investigation of Vice Stocks.” His study covered the period October 1996 to October 2016.

Richey employed the single-factor CAPM 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 outperforms the S&P 500, a benchmark to approximate the market portfolio, on a risk-adjusted basis. His dataset included 61 corporations from vice-related industries. Following is a summary of his findings:


  • For the period October 1996 through October 2016, the S&P 500 returned 7.8% per annum. The “Vice Fund” returned 11.5%.
  • The alpha, or abnormal risk-adjusted return, shows 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, indicate that the Vice Fund portfolio beta is between 0.59 and 0.74, indicating that the vice portfolio exhibited 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 has 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 shrinks to just -0.05 and the value loading turns slightly negative, also at -0.05, and both are statistically significant. In the five-factor model, the vice portfolio loads 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 outperform on a risk-adjusted basis. However, in the five-factor model, the alpha virtually disappears, falling to just 0.1% per year. This result helps explain the performance of vice stocks relative to the market portfolio that previous models fail to capture. The r-squared figures ranged from about 0.5 to about 0.6. Richey concluded that the higher returns to vice stocks is because they are more profitable and less wasteful with investments than the average corporation.

Richey’s findings are consistent with other studies on sin stocks.

Further Evidence

Harrison Hong and Marcin Kacperczyk, authors of the 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 1965 through 2006, a U.S. portfolio long sin stocks and short their comparables had a return of 0.29% per month after adjusting for the four-factor model.

As out-of-sample support, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a 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.

As further evidence that avoiding sin stocks comes at a price, Elroy Dimson, Paul Marsh and Mike Staunton found that, when using their own industry indices that covered the 115-year period of 1900 through 2014, tobacco companies beat the overall equity market by an annualized 4.5% in the U.S. and by 2.6% in the U.K. (over the slightly shorter 85-year period from 1920 through 2014). Their study was published in the 2015 Credit Suisse Global Investment Handbook.

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 comprise annual scores on six broad dimensions of governance.


Dimson, Marsh and Staunton found 14 countries that posted a poor score, 12 that were acceptable, 12 that were good and 11 with excellent scores. 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 note, 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 price for corruption risk and demand a premium for taking it. 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).

Socially Responsible Factors
Meir Statman and Denys Glushkov contributed to the literature on SRI with their study, “Classifying and Measuring the Performance of Socially Responsible Mutual Funds,” which was published in the Winter 2016 issue of The Journal of Portfolio Management. Their contribution was to add two social responsibility factors to the commonly used four-factor model (beta, size, value and momentum).

The first social responsibility factor they propose is the top-minus-bottom factor (TMB), consisting of employee and customer relations, environmental protection, diversity and products. The second factor is the accepted-minus-shunned factor (AMS), consisting of the difference between the returns of stocks of companies commonly accepted by socially responsible investors and the returns of stocks of companies they commonly shun. 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 note: “The two social responsibility factor betas capture well 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 January 1992 (when data first becomes 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 rank 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 is a value-weighted portfolio of the accepted companies’ stocks, and its short side is a value-weighted portfolio of shunned companies' stocks. The authors constructed the TMB and AMS portfolios as of the end of each year. 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 a negative 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 detracts 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 produces negative alpha is consistent with both the theory I mentioned previously and prior research.


An Anomaly
The finding of positive alpha for the TMB factor, however, is a puzzle for the same reason that the negative alpha for AMS should 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.

A possible explanation is that perhaps the alpha could be explained by exposure to another factor (such as quality or low beta) not included in the four-factor model (beta, size, value and momentum).

Other explanations can be found in the behavioral finance literature. For example, the 2011 study from Alex Edmans, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,” found that stocks of companies with highly satisfied employees earned higher returns than other stocks.

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.

And the 2007 study by Alexander Kempf and Peer Osthoff, “The Effect of Socially Responsible Investing on Portfolio Performance,” found that stocks of companies that ranked high overall on community, diversity, employee relations, environment, human rights and products did better than stocks that ranked low on those measures. In each case, higher returns could result from investor myopia—they tend to focus on possible negative short-term costs (such as higher wages) and underestimate long-term benefits.

One final comment: Investors may be aware that there are trade-offs between wants, and some are willing to trade the utilitarian benefit of higher expected returns for the expressive and emotional benefits of avoiding the stocks of shunned companies.

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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