Swedroe: Costs Of Socially Responsible Investing

Socially responsible investing (SRI) aligns ethical and financial concerns for investors. SRI has gradually developed over time to include the consideration of firms’ environmental, social and governance (ESG) performance.

Of note is that, while SRI has evolved, the original practice of negative screening for the stocks of companies involved in harmful or controversial activities (so-called sin stocks) remains the most common SRI strategy today.

Pieter Jan Trinks and Bert Scholtens contribute to the literature on SRI investing with their study, “The Opportunity Cost of Negative Screening in Socially Responsible Investing,” which appears in the May 2015 issue of the Journal of Business Ethics.

The authors employed a comparative analysis on 14 potentially controversial issues over the period 1991 through 2012. In contrast to most other studies, they did not rely on broad industry classification, discarding complete industries.

Instead, they checked the 14 issues at the level of the individual firm, investigating more than 1,600 stocks (about 7% of the global investment universe, and an even higher 12% of the U.S. equity universe).

Their sample population consisted of firms in developed and emerging markets across the world (30% from North America, 28% from Asia, 27% from Europe, 7% from Australasia, 5% from South America and 3% from Africa). It appears that most controversial stocks are from the United States (23%), Australia and Japan (7%), and Canada, India and China (5%). Returns were value-weighted.

The issues the authors analyzed in their study were abortion/abortifacients, adult entertainment, alcohol, animal testing, contraceptives, controversial weapons, fur, gambling, genetic engineering, meat, nuclear power, pork, (embryonic) stem cells and tobacco.

Some of these issues are highly prevalent reasons for exclusion in socially responsible investing (alcohol, weapons, gambling, tobacco, adult entertainment, for instance); others are less well-established and institutionalized. The authors, however, noted that all the issues they evaluated “are being used in private mandates of investors, and the number of controversies seems to increase.”

Results
Following is a summary of their findings:

• Controversial investments generally yield positive abnormal (risk-adjusted) returns using the Carhart four-factor model (beta, size, value and momentum). Screening them out produces suboptimal financial performance.
• Practically all controversial cluster portfolios significantly outperform the market, and do so with statistical significance at the 5% level (and, in most cases, at the 1% level). These findings suggest that negative screening can have significant financial costs, which should be regarded as an opportunity cost.
• Some controversial issues can be financially more attractive than others. Alcohol, animal testing, contraceptives, fur, genetic engineering and tobacco display statistically significant as well as economically significant positive abnormal returns. These findings align with the theory that firms with controversial business activities have to come up with extra-financial performance to keep attracting investors. In this respect, adult entertainment and stem cells are exceptions, as these issues exhibit mildly significant underperformance.
• In contrast to prior research, screening is applicable to a large number of stocks, representing substantial market capitalization. Thus, there is evidence that negative screening results in a sacrifice of diversification benefits.
• Controversial issues other than the usually studied ones also are material and therefore relevant to the study of responsible and “sin” investing.

Other Evidence

These findings are consistent with those of Greg Richey, author of the study “Sin Is In: An Alternative to Socially Responsible Investing?”, which appears in the Summer 2016 issue of The Journal of Investing. Richey examined the risk­adjusted returns of a portfolio constructed of firms from sin- or vice-related industries. Using data from the Center for Research in Securities Prices covering the period May 1995 to May 2015, he analyzed the performance of a “vice” portfolio made up of 41 corporations against the market portfolio.

The firms in his vice portfolio came from the alcohol, tobacco and gambling industries listed on the NYSE, Nasdaq or Nasdaq OTC. He then added firms in the defense industry to complete the portfolio of vice stocks. Richey found that the “Vice Fund” produced a greater risk-adjusted return (compared to the results of the Carhart four-factor model: beta, size, value and momentum) over the market portfolio throughout the sample period. The results were statistically significant at the 5% confidence level.

Further supporting evidence is provided by Harrison Hong and Marcin Kacperczyk, authors of “The Price of Sin: The Effect of Social Norms on Markets.” Their study, published in the August 2009 issue of the Journal of Financial Economics, found that “sin” stocks outperform benchmarks by about 30 basis points a month. And Frank Fabozzi, K.C. Ma and Becky Oliphant, authors of the study “Sin Stock Returns,” which appeared in the Fall 2008 issue of The Journal of Portfolio Management, found that sin stocks outperformed by wide margins.

The authors of the latter paper warned: “Trustees or fiduciaries who develop institutional investment policy statements should fully understand the economic consequences of screening out stocks of companies that produce a product inconsistent with their value systems. In addition, institutional investors should question if the cost to uphold common social standards is worthwhile.”

Summary

These results all indicate that there is a financial price to pay for choosing the SRI route, and it comes in the form of reduced risk-adjusted returns and less efficient diversification.

However, it’s worthwhile to recognize that, for some investors, such financial consequences are not very important, or might not play a role at all. For them, their values have greater importance than maximizing risk-adjusted returns. It’s a very personal decision as to whether values or returns should drive investment.

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