Swedroe: Sin’s Great For Returns

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.

Supporting Evidence

One of the largest SRI investors is Norway’s $870 billion Government Pension Fund, the country’s sovereign wealth fund. The fund divests companies from its investment portfolio based on two types of exclusions.

The first is product-based exclusions, which include weapons, thermal coal, and tobacco producers and suppliers. The second is conduct-based exclusions, which involve companies with a track record of human rights violations, severe environmental damage and corruption.

According to Norges Bank Investment Management, which manages the fund’s assets, the fund has missed out on 1.1 percentage points of additional gain due to the exclusion of stocks on ethical grounds over the past 11 years. The following list describes the impact of some of the fund’s specific product-based exclusions relative to the benchmark, the FTSE Global All Cap Index:

• The exclusion of tobacco companies and weapon manufacturers reduced the return of the equity portfolio by 1.9 percentage points.
• Divesting from tobacco manufacturers reduced the portfolio’s return by 1.16 percentage points.
• Avoiding weapons-makers decreased the portfolio’s return by 0.75 percentage points.
• Conduct-based exclusions of mining companies have had a minor effect on the portfolio’s return versus the benchmark index.

Findings such as these have led to the development of an investment strategy that focuses on the violation of social norms 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.

Sin’s ‘Price’

Greg Richey contributed 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 (which added 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 year. 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, in turn 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-factor 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. And 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 occurred because they are more profitable and less wasteful with investments than the average corporation.

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 on 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. In a recent article, I provided a more detailed analysis of this study and a risk-based analysis of socially responsible funds.

Additional Evidence

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 indexes that covered the 115-year period 1900 through 2014, tobacco firms 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 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 from 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).

Summary

There are many forms of SRI and ESG investing, and every investor has their own personal views. Thus, it’s no surprise that each SRI/ESG fund has its own fund construction methodology.

For example, consider the “gay benefits” issue. Some funds exclude companies like Walt Disney for having gay-friendly policies. On the other hand, the Meyers Pride Value Fund only invests in companies with partner employee benefits and policies that prohibit discrimination.

There are even funds designed for Catholics (Ave Maria Mutual Funds), Muslims (Amana Mutual Funds Trust), Presbyterians (New Covenant Funds) and Christians of all denominations (The Timothy Plan). Our capitalist system is great at responding to demand.

The preceding evidence suggests that investors who desire to express their views on ESG or religious issues may pay a price in the form of lower returns. The reason is that some screens, like those that eliminate sin stocks, lead to lower returns.

The bottom line is that if you are considering SRI/ESG as an investment strategy, you should carefully evaluate fund construction methodology before making any decisions. It may even be difficult to find a fund that exactly meets your own personal criteria. For investors with sufficiently large investable assets, there are asset managers that will build individually tailored SRI/ESG portfolios (that provide the added benefit of tax efficiency).

Finally, investors who are aware of the trade-off between wants (better returns versus expressing their beliefs) may still be willing to trade the utilitarian benefit of greater forward-looking return expectations for the expressive and emotional benefits of avoiding the stocks of shunned companies. An alternative is to invest without consideration for these issues and then donate any higher return directly to your most important causes.

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