Socially responsible investing (SRI) has captured nearly a quarter of U.S.-based assets. New evidence from one of the world’s largest sovereign wealth funds shows that those investors are sacrificing significant performance. Indeed, those clients are giving up more than 1% a year – effectively doubling the typical 1% AUM advisory fee.
SRI/ESG Investing
Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing: investors seek profitable investments that meet their personal standards. For instance, some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages, weapons or rely on animal testing in research and development. Other investors may also be concerned about environmental, social, governance (ESG) or religious issues. 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 assets 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 the US SIF Foundation. While SRI and ESG investing continue to grow in popularity, economic theory suggests that if a large enough proportion of investors choose to avoid “sin” businesses, their 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).
One of the largest SRI investors is Norway’s Government Pension Fund, the country’s sovereign wealth fund. The $870 billion fund excludes two types of companies from its investment portfolio: Product-based exclusions include weapons, thermal coal and tobacco producers and suppliers; conduct-based exclusions are companies with a track record of human rights violations, severe environmental damage and corruption. According to Norges Bank Investment Management, which manages the sovereign wealth fund’s assets, the fund has missed out on 1.1 percentage points of additional gain due to the exclusion of stocks on ethical grounds over the past 11 years. The fund’s benchmark was the FTSE Global All-Cap index.
According to the report, product-based exclusions had the following impact:
- The exclusions of tobacco companies and weapon manufacturers reduced the return of the equity portfolio by 1.9 percentage points.
- Divesting from tobacco manufacturers reduced the portfolio return by 1.16 percentage points.
- Avoiding weapons makers decreased the return by 0.75 percentage points.
- Exclusions of mining companies had a minor effect on the return.
Findings such as these have led to the development of an investment strategy that focuses on the violation of social norms 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 strategy.
Greg Richey studied the “price of sin” in his January 2017 paper, “Fewer Reasons to Sin: A Five-Factor Investigation of Vice Stocks.” His study covered the period from October 1996 to October 2016. Richey employed the single-factor Capital Asset Pricing 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 outperformed the S&P 500 Index, a benchmark to approximate the market portfolio, on a risk-adjusted basis. His data set included 61 corporations from vice-related industries. The following is a summary of his findings:
- For the period from October 1996 through October 2016, the S&P 500 returned 7.8% per year. The “Vice Fund” returned 11.5%.
- The alpha, or abnormal risk-adjusted return, showed 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, indicated that the Vice Fund portfolio beta was between 0.59 and 0.74, indicating that it had 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 had 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 shrank to just -0.05 and the value loading turned slightly negative, also at -0.05, and both are statistically significant. In the five-factor model, the vice portfolio loaded 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 outperformed on a risk-adjusted basis. However, in the five-factor model, the alpha virtually disappeared, falling to just 0.1% per year. This result helps explain the performance of vice stocks relative to the market portfolio that previous models failed to capture. The R-squared figures ranged from about 0.5 to about 0.6. Richey concluded that the higher returns to vice stocks were because those corporations’ investments were more profitable and less wasteful than the average corporation.
Richey’s findings are consistent with other studies on sin stocks.
By Larry Swedroe, read the full article here.
