Swedroe: When Vice Outperforms Virtue

March 03, 2017

  • 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.


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