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:


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