Does Ethical-Based Investing Impact Returns?2016-02-09
Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that you’re seeking not only profitable investments, but also investments that meet your personal standards. Some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages or weapons, or firms that rely on animal testing as part of their research and development efforts. Other investors may be concerned about social, environmental, governance, labor or religious issues.
It is important to note, however, that SRI encompasses many personal beliefs and doesn’t reflect just one set of values. Therefore, it’s no surprise that each socially responsible fund relies on its own carefully developed “screening” system.
Analyzing the Numbers
According to the Social Investment Forum (SIF), U.S. SRI assets under management registered an increase from $639 billion in 1995 to $3.7 trillion in 2012, and an increase in their relative market share from 9% to 11% over the same period. Given their growth, an important question is whether “ethics-based” investing can impact returns. Sadok El Ghoul and Aymen Karoui — the authors of the December 2015 study, How Ethical Compliance Affects Portfolio Performance and Flows: Evidence from Mutual Funds — sought the answer to that question.
The authors applied value-weighted scores using firm-level holdings to assess the level of corporate social responsibility (CSR) of a fund. This allowed them to compare fund performance based on the CSR criterion. To rate individual companies, they employed a KLD database. KLD Research & Analytics is a leading authority on social research for institutional investors, offering research, benchmarks, compliance and consulting services analogous to those provided by financial research service firms.
The authors considered two competing hypotheses. On the one hand, investing in firms that comply with social responsibility practices is likely to reduce the set of investment opportunities available and increase their monitoring costs. Ethical compliance would then negatively impact financial performance. On the other hand, fund managers that target socially responsible firms might in fact target firms with solid financial fundamentals, which in turn would translate into higher performance. In other words, the multiple screening steps taken by fund managers may eliminate poorly managed companies with underperforming stocks. In this case, investing in socially responsible stocks would be a value-generating strategy.
Their study covered the period from 2003 through 2011 and 2,168 U.S. equity mutual funds. To measure risk-adjusted returns, the authors used the four factors of market beta, size, value and momentum. The following is a summary of their findings:
- High-CSR funds attract larger flows.
- High-CSR funds tend to hold fewer stocks; they are less diversified.
- There is strong evidence that an increase in the level of CSR comes at the expense of a reduction in performance. Said another way, the CSR level of the portfolio is negatively related to its risk-adjusted performance. This result stands controlled for common fund characteristics such as volatility, flows, the size of the assets under management, the number of stocks, the expense ratio and turnover.
- The alpha, or the annualized risk-adjusted return (net of fees), of low-CSR funds was -0.8%, while the alpha of high-CSR funds was -1.5%. The difference, 0.7%, was highly statistically significant (t-stat of 5.8). The difference could not be explained by the expense ratios because they were virtually identical (1.24% for low-CSR funds and 1.21% for high-CSR funds).
- The CSR level negatively predicts the next year’s fund performance.
- There is no evidence of persistence in performance beyond a horizon of one year. Funds with a high CSR score exhibit weaker persistence or higher reversal in their performance.
- Evidence in the literature on mutual funds has shown that investor flows respond positively and significantly to past performance. However, this relationship weakens as the level of CSR increases. Investors in funds with higher ethical standards become less responsive to past performance and derive their utility from non-financial attributes. As the level of ethical compliance increases, it becomes more difficult for investors to find similar investment alternatives and therefore they may be more reluctant to switch to other funds, even when these funds register poor performance.
The authors noted that their findings were consistent with those of a study appearing in the November 2015 issue of the Journal of Banking and Finance, Do Social Factors Influence Investment Behavior and Performance? Evidence from Mutual Fund Holdings. Funds that are more invested in “sin” stocks display higher risk-adjusted performance.
The findings mentioned above are also consistent with those from Harrison Hong and Marcin Kacperczyk, authors of the study, The Price of Sin: The Effects of Social Norms on Markets, which appeared in the July 2009 issue of the Journal of Financial Economics.
They found that for the period from 1965 through 2006, a portfolio long sin stocks and short their comparables had a return of 0.29% per month after adjusting for a four-factor model comprised of the three Fama-French factors (beta, size and value) and the momentum factor. The statistics were economically significant. In addition, as out-of-sample support, they found that sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a year.
The Bottom Line
The conclusion that we can draw from these studies is that social norms have important consequences for the cost of capital of “sin” companies. They also have consequences for SRI investors, who pay a price in the form of lower expected returns and less effective diversification.
While many investors will vote “conscience” over “pocketbook,” there is an alternative to socially responsible investing at least worth considering: avoid socially responsible funds and donate the higher expected returns to the charities that you are most passionate about. In that way you can directly impact the causes you care deeply about and get a tax deduction at the same time.