Sustainable and Responsible Investing: Is There a Price to Pay? February 8, 2016 by Larry Swedroe Consumers can use their market power to demonstrate their aversion to certain business activities by choosing not to purchase goods or use services from companies that, in their minds, are selling immoral products. Similarly, investors can decide not to invest in such companies. For example, in the 18th century, religious groups in the United States sometimes placed restrictions on their investments, including bans on loans to companies engaged in distilling, tobacco production or the distribution and operation of gambling facilities. A more recent example is the international outcry raised in the 1970s for South Africa to end apartheid. Many investors, both individual and institutional, divested from multinational companies that did business in South Africa. Although economic sanctions against South Africa ended in 1993, many investors have continued the practice of applying a set of moral standards to every company, wherever they operate. Today, we call this approach sustainable and responsible investing (SRI). It s also widely referred to as socially responsible investing. And while SRI is not generally thought of as an alternative investment in the same way hedge funds or commodities are, it represents an alternative for many investors. With this in mind, I ll do an analysis of SRI funds as part of my continuing series on the performance of actively managed mutual funds. To create the list of funds to analyze, I began with US SIF. The organization utilizes Bloomberg's environmental, social and governance (ESG) data service, which provides multi-year, as-reported data on more than 10,500 companies worldwide. I then screened for all equity funds that had at least a 15- year track record, at least $500 million in assets under management and for which there was also a comparable Vanguard index fund (Vanguard being the leading provider of index funds). The choice of Vanguard benchmark fund is based on the SRI fund s investment style as assigned by Morningstar. Where multiple share classes were available, I use the lowest-cost fund. These parameters left me with seven funds to evaluate. The table below shows the assets under management, the expense ratios and the returns data for the seven SRI funds and their comparable Vanguard benchmarks for the 15-year period ending December Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.
1, 2015. Before considering the results, it s important to note that, by limiting the funds I analyzed to the largest, I am likely injecting survivorship bias into the data. The reason for this is that funds with the most AUM are likely to have been the most successful. Funds with lesser amounts of AUM might not have performed as well, and they may not even have survived the full period. 15-Year Period Ending Dec. 1, 2015 Fund Assets Under Symbol Management (billions) Expense Ratio (%) Annualized Return (%) U.S. Large-Cap Blend Domini Social Equity Fund Investor Shares DSEFX $1.0 1.16 3.80 Parnassus Fund PARNX $0.8 0.84 6.54 TIAA-CREF Social Choice Equity Fund TISCX $2.7 0.18 5.43 Average 0.73 5.26 Vanguard 500 Index Fund Admiral Shares VFIAX $40.0 0.08 5.20 U.S. Large-Cap Growth Parnassus Core Equity Fund PRBLX $12.1 0.87 9.26 Calvert Equity Portfolio CEYIX $2.3 0.62 6.87 Calvert U.S. Large Core Responsible Index A Neuberger Berman Socially Responsible Fund CSXAX $.6 0.75 3.93 NBSRX $2.3 0.85 7.38 Average 0.77 6.86 Vanguard Large Growth Index Fund Admiral Shares VIGAX $21.2 0.09 5.09 The following is a summary of the results: Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.
In the large-blend asset class, two of the three SRI funds outperformed the benchmark Vanguard fund. The average outperformance, however, was a modest 0.06%. The SRI funds had to overcome an average expense ratio 0.65 percentage points higher than the benchmark just to match it. In the large-growth asset class, three of the four SRI funds outperformed. The average outperformance was 1.77%. The SRI funds had to overcome an average expense ratio 0.68 percentage points higher than the benchmark just to match it. Factor Analysis We ll now take a look at the seven SRI funds in the preceding table using the analytical tools and data available through Portfolio Visualizer. Factor analysis provides important additional insights regarding performance, as Morningstar asset class categories are very broad and actively managed funds often style drift. The table below shows the results of the three-factor (beta, size and value), four-factor (adding momentum) and six-factor (adding quality and low beta) analyses. The data covers the 15-year period from October 2000 through September 2015. The t-stats are in parentheses. October 2000-September 2015 Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.
Fund Symbol Three-Factor Annual Alpha (%) Four-Factor Annual Alpha (%) Six-Factor Annual Alpha (%) Domini Social Equity Fund Investor Shares -1.1 DSEFX (-1.3) -0.8 (-0.9) -2.3 (-2.6) Parnassus Fund 0.6 PARNX (0.2) 1.5 (0.7) 1.5 (0.6) TIAA-CREF Social Choice Equity Fund TISCX -0.5 (-0.9) -0.4 (-0.8) -1.4 (-2.3) Parnassus Core Equity Fund PRBLX 4.3 (3.4) 4.3 (3.4) 2.4 (1.9) Calvert Equity Portfolio CEYIX 1.9 (1.6) 2.1 (1.8) -0.4 (-0.3) Calvert U.S. Large Core Responsible Index A -1.5 CSXAX (-1.8) -1.1 (-1.4) -1.7 (-2.2) Neuberger Berman Socially Responsible Fund 1.9 NBSRX (1.6) 1.8 (1.5) 0.2 (0.2) Average 0.8 1.1-0.2 When we examine the results from the three-factor analysis, we find that four of the seven SRI funds generated positive annual alphas, and one of those positive alphas was statistically significant at the 5% level. The average annual alpha was 0.8%. When we look at results from the four-factor analysis, we also find that four of the seven SRI funds generated positive annual alphas. And again, one fund posted a positive alpha that was statistically significant at the 5% level. The average annual alpha was an even larger 1.1%. When we include all six factors, we find that three of the seven funds generated positive annual alphas. However, none were statistically significant at the 5% level (although one came close with a t- stat of 1.9). On the other hand, three of the four funds that generated negative alphas showed Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.
statistical significance at the 5% level. The average annual alpha was now -0.2%. The negative six-factor alpha, compared to the positive three- and four-factor alphas, shows the higher average returns of the SRI funds were a result of loading (an average of 0.19) on the quality factor. SRI stocks tend to be quality stocks. We know that there was no alpha in the three- or four-factor analysis from the low-beta factor because in the six-factor analysis the loading was virtually zero. Quality stocks have these four broad characteristics, which are indicative of safer companies: Profitability: This is measured by such metrics as return on equity, return on assets, margins and cash flows. Growth: This is measured by the prior five-year growth in the profitability metrics. Safety: This is measured by both market beta and volatility, as well as by fundamental-based measures such as leverage, volatility of profitability and credit risk. Payout: Management s agency problems are diminished if free cash flows are reduced through higher net payouts (including dividends and buybacks offset by new share issuance). The screening process I employed to select the funds for my analysis likely injected biases favoring the SRI fund industry, but the evidence presented above shows that investors, at least those in the funds I evaluated, were able to feel good about their investments without sacrificing performance. Before drawing any firm conclusions, consider the following. As the data presented in the tables indicate, SRI funds are typically more expensive than index funds and passive funds in general. One reason is that they incur the extra costs of screening out undesirable stocks. Those extra costs create hurdles that penalize returns. Investors can purchase funds that load on the quality factor without resorting to SRI screens that limit diversification. For example, the passively managed small-value OMNI funds from Bridgeway load heavily on the quality factor. The value funds of Dimensional Fund Advisors (DFA) do too. Both of these fund families provide exposure to the size and value factors as well, allowing for more diversification across asset classes/factors. (In the interest of full disclosure, my firm, Buckingham, recommends Bridgeway and DFA funds in constructing client portfolios.) SRI investors sacrifice diversification relative to a broad-based market index fund since they are investing from a universe of stocks that meet the funds screening process. Further, those funds are typically domestic and large cap. Thus, investors sacrifice exposure, particularly to small and value stocks and perhaps international and emerging market stocks as well. As a result, they lose exposure to the higher expected returns provided by small, value and emerging-market stocks. SRI investors could also be accepting other risks. For instance, because such investors avoid investing in sin stocks, they may not be fully diversified across industries. There is one other important point to consider. Economic theory tells us that, because there are now about $4 trillion in SRI investments avoiding sin stocks, the cost of capital of sin stocks should be Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.
higher than it would otherwise be. On the other hand, the cost of capital of non-sin stocks is driven lower. In other words, by avoiding investing in sin stocks, investors make those stocks cheaper (smaller and more value-oriented). And because the flip side of the cost of capital is the expected return to investors, SRI investors are missing out on the higher expected returns of sin stocks. The price of sin In The Price of Sin: The Effects of Social Norms on Markets from the July 2009 issue of the Journal of Financial Economics, authors Harrison Hong and Marcin Kacperczyk provide evidence to support the hypothesis that there s a societal norm against investing in sin stocks and that this does impact the cost of capital. The following is a summary of their findings: When compared to stocks of otherwise comparable characteristics, sin stocks have less institutional ownership. Specifically, sin stocks have approximately 18% lower institutional ownership than comparable stocks (23% versus 28%). Sin stocks are held less by norm-constrained institutions, such as pension plans, than they are by natural arbitrageurs, such as mutual funds or hedge funds. The prices of sin stocks are relatively depressed and, therefore, have higher expected returns than otherwise comparable stocks. This is consistent with such stocks being neglected by normconstrained investors and facing greater litigation risk (for instance, tobacco stocks) heightened by social norms. For the period from 1965 through 2006, a portfolio long sin stocks and short their comparables has a return of 0.29% per month after adjusting for a four-factor model comprising of the three Fama-French factors (beta, size and value) and the momentum factor. The statistics were economically significant. The market-to-book ratios of sin stocks are on average about 15% lower than those of other comparable companies. These valuation ratios, using a Gordon growth model calibration, imply excess returns of about 2% a year. As out-of-sample support, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a year. The conclusion we can draw from this study is that social norms have important consequences for the cost of capital of sin companies. They also have consequences for investors who pay a price to forego such stocks 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 that s at least worth considering: Avoid SRI 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 most about and get a tax deduction at the same time. Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.