Sustainable, or socially responsible, investing (SRI) has gained quite a lot of traction in portfolio management in recent years. Total assets managed by agents that included environmental, social and governance (ESG) criteria in their decision-making processes were estimated at $3.7 trillion by 2013, out of a total of $33.3 trillion in the U.S. investment marketplace.
Last week, we began our discussion about SRI with a look at whether ethics-based investing can impact returns. Today, we will conclude it by exploring SRI and mutual fund performance.
Analyzing the Literature
Thomas Walker, Kerstin Lopatta and Thomas Kaspereit contribute to the literature on SRI with their study — “Corporate Sustainability in Asset Pricing Models and Mutual Funds Performance Measurement” — which appeared in the November 2014 issue of Financial Markets and Portfolio Management.
Walker, Lopatta and Kaspereit developed a specific sustainability factor that augments traditional asset pricing models. They called their sustainability factor GMU (or “green” minus “unsustainable”). The GMU scores are based on data from the MSCI KLD database, which is considered the gold standard and is widely used in sustainability research.
The GMU factor was tested by splitting stocks into quintile portfolios based exclusively on a sustainability score. Quintile 1 contained stocks with the lowest sustainability scores while Quintile 5 contained stocks with the highest. Portfolios were rebalanced annually. After creating the five test portfolios, the value-weighted returns of these portfolios were regressed on the four factors of market beta, size, value and momentum, as well as the new sustainability factor. The study covered the period from June 1992 through June 2012.
The following is summary of the authors’ findings:
- Common factors already explain well the returns of the five test portfolios.
- The sustainability factor has no ability to explain ex-ante (expected) stock market returns.
- Stocks with similar levels of corporate sustainability share similar return characteristics.
- There is no sustainability premium.
- Abnormal stock market performance from sustainability funds is negative and doesn’t differ significantly from funds in the control sample.
A surprising finding from the study was that of 87 U.S. domestic equity mutual funds with sustainability screens, only nine (or 10.3% of them) loaded significantly positive on the sustainability factor, while 15 (or 17.2% of them) had significant negative loadings.
In addition, the average coefficient estimate on the sustainability factor is significantly negative for funds with sustainability screens, and only slightly less than the average coefficient for a control sample of 11,150 conventional U.S. domestic equity funds. A possible explanation is that the GMU factor, which is based on the MSCI KLD rating, captures a different definition of sustainability than the sustainability criteria maintained by most mutual funds in the sample. Another explanation is that not all stocks have a KLD rating. And finally, it’s possible that the investment process of these mutual funds fraudulently diverges from their alleged focus.
Given that the commonly used factor models already explain a very high percentage of the differences in returns of diversified portfolios, it shouldn’t come as any surprise to learn that a sustainability factor would not add explanatory power. For the same reasons, it shouldn’t come as a surprise that there wasn’t any sustainability premium. And because of the screens imposed, SRI portfolios are by definition less diversified and thus should be considered less efficient than their non-SRI counterparts.
The Bottom Line
Investors interested in SRI should be aware that the research has shown that “sin” stocks do have higher returns. In other words, there’s a price to being a socially responsible investor who screens out sin stocks.
For example, 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 — 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 composed of the three Fama-French factors (beta, size and value) and the momentum factor.
Similarly, as we mentioned last week, the authors 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 — found that funds more invested in “sin” stocks display higher risk-adjusted performance.