An increasingly popular method of investing has been socially responsible investing (SRI), an ethics-based strategy in which investors construct portfolios that typically eliminate firms on an exclusionary (or negative) basis. Among the equities often excluded, either individually or from SRI mutual funds, are ones belonging to companies engaged in “sin” industries, such as alcohol, tobacco and gaming. SRI has now been expanded to reflect a broader category, referred to as ESG (environmental, social and governance).
At the same time, a newer investing niche has emerged, one that seeks to take advantage of the fact that if some investors exclude “sin stocks” from their portfolios, the reduced demand will lower valuations and lead to higher returns. Thus, an investment strategy exists that can be referred to as “vice investing” or “sin investing,” and is in direct contrast to SRI.
What Studies Show
Greg Richey, the 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, examined the risk-adjusted returns of a portfolio constructed from firms in sin- or vice-related industries.
Richey used data from the Center for Research in Securities Prices covering the period from May 1995 to May 2015 and examined the performance of a vice portfolio consisting of 41 corporations against the market portfolio. These firms were in the alcohol, tobacco and gambling industries, and their stock was listed on the NYSE, NASDAQ or NASDAQ OTC. Richey added companies in the defense industry to complete his portfolio of vice stocks.
The following is a summary of his findings:
- The “Vice Fund” produced a higher 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 percent confidence level.
- The results held for four individual-industry portfolios, with the exception of a negative but statistically insignificant alpha for the tobacco portfolio (which did, however, outperform during the financial crisis).
- The vice portfolio not only exhibited lower overall volatility than the market portfolio, but also lower downside volatility, providing some protection against tail risk.
- The statistically significant results for both the total portfolio and the specific, vice-industry portfolios imply that firm size, book-to-market and momentum factors help explain the vice portfolios’ performance.
Richey’s findings are consistent with those of prior research. A study by Harrison Hong and Marcin Kacperczyk, The Price of Sin: The Effect of Social Norms on Markets, which was published in the August 2009 issue of The Journal of Financial Economics, found that sin stocks outperform benchmarks by roughly 30 basis points per 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. They 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.”
Unfortunately for investors interested in pursuing this type of strategy, there is currently only one mutual fund available in this space, specifically the USA Mutuals Barrier Fund Investor Class Shares (VICEX). I say “unfortunately” because the fund carries quite a sinful expense ratio of 1.48 percent. According to MutualFunds.com, despite its sinful expense ratio, for the 10-year period ended June 8, 2016, the fund returned 7.60 percent, outperforming the large blend fund category, which returned 6.71 percent, and slightly outperforming the much less expensive Vanguard 500 Index Fund (VFINX), which returned 7.51 percent.
We can also analyze the performance of the fund by using the regression analysis tool available at Portfolio Visualizer. For the period from October 2002 through April 2016, VICEX produced a four-factor (beta, size, value and momentum) alpha of 1.60 percent (though it wasn’t statistically significant), which is amazing given the burden imposed by the fund’s 1.48 percent expense ratio.
The Bottom Line
However, if we add the expense ratio back, the 3.04 percent gross alpha is fairly consistent with the 30-basis-points-per-month outperformance found by Richey. If we expand the analysis to include the quality and low-beta factors, the alpha becomes negative (though not statistically significant) at 0.77 percent, which would still be a positive 0.67 percent on a gross basis. At least before VICEX’s very high expenses, sin investing was rewarded. Perhaps what interested investors need is a less-sinful version of the fund (at least in terms of expense).