Does Socially Responsible Investing (SRI) Outperform?
Table of contents
In our recent article on Swell Investing, we took a look at some impact investing portfolios that allow investors to only invest in companies that “do good”. This is called “Socially Responsible Investing” and the general messaging from the many SRI fintechs that are sprouting up is that SRI outperforms the broader market. You’ve never heard someone say “well, companies that spend loads of money on cleaning up industrial waste properly underperform the broader market but we need to invest in them anyway“. Nobody would ever say that because based on all the marketing spiels we hear, that’s just not true. We need to ask ourselves though, what if that it is true? What if to invest in SRI meant that we would not achieve the same sort of returns by just investing in the entire market? Or even investing in the so called “sin stocks” or “vice stocks”?
All kinds of themes exist now for SRI investing, and not all are going to outperform. It’s just not possible. However, there are millions of ways to measure the data and paint performance in a positive light over any time frame. Here are some key themes identified by MSCI, a company that assigns “ratings” to each company based on how well they adhere to Environmental, Social and Governance (ESG) factors which is pretty much what SRI is all about:
Let’s take human capital as an example. One of the focal points in this category would be female representation on boards. A piece of research was recently released by MSCI that highlighted how over a 5-year term, “U.S. companies that began the period with at least three women on the board experienced median gains in Return on Equity (ROE) of 10 percentage points and Earnings Per Share (EPS) of 37%“. Why a 5-year period? Our investment horizon certainly isn’t five years. What if we extend that to 10 years, then what happens? Just how much data do we have and how far back can we go?
The point here is that in all likelihood, many of these themes won’t outperform. Generating alpha is ridiculously tough, which is why 80% of fund managers cant beat a benchmark. Are we supposed to believe that SRI is a method that everyone should now use going forward which will always generate alpha? While that sounds good on paper, it’s just not true.
Now we can imagine many people saying “well you’re not pointing out study XYZ that shows otherwise” and that’s just the point we’re trying to make. You can literally come up any conclusion you want just by choosing different variables and timelines. It’s just like how eating sour cream increases the likelihood that you’ll end up killed in a motorcycle accident:
Everybody knows that when it comes to investing, we should be particularly suspicious of spurious correlations, which is why it’s so surprising nobody challenges some of these studies which are based on short-term data that claims a feel-good factor demonstrates outperformance over the long-term. Companies are being pressured to make certain decisions based on the final ultimatum which is “well, Study X shows that Action Y outperforms the market“. That should never be used as an argument by anyone who has a basic understanding of how investing works.
If we look at some of the literature out there, we see that in fact this is a highly debated topic. Look no further than the aptly titled paper “The real effects of socially responsible investing: Disagreement on the doing well while doing good hypothesis and the cost of capital” which goes on to say:
Socially responsible investors believe that firms with a higher corporate social performance (CSP) also have a higher corporate financial performance (CFP). This so called “doing well while doing good” hypothesis is currently hotly debated in both professional and academic circles.
Like most academic papers focused on financial topics, it’s boring as hell to read, but the point it makes is a good one. Just because a company behaves well doesn’t necessarily mean they will perform well. In fact, some academics argue the opposite. In a paper titled “The Performance of Socially Responsible Investing”, a portfolio of “vice stocks” is compared to a portfolio of “good stocks” over a period of 1997 to 2006. What they found was fascinating. In a nutshell, what happened was that the “good stocks” outperformed up until about 2000. At that point in time, all the demand for “good stocks” increased their cost of capital such that the vice stocks then began outperforming simply based on the fact that everyone was piling into the “good stocks”. In other words, the paper suggests that “investors underestimate the benefits of being socially irresponsible“. Nobody talks about that in their marketing materials.
Another paper titled “Socially Responsible Investing vs. Vice Investing ” examines the outperformance of “sin stocks” in the context of mutual funds, and it uses a much longer period of almost 20 years (1990 to 2009). In this study, we see that while SRI stocks outperformed in the short-term, over the long run they lost out to sin stocks again. An article by CNBC in summer of last year talked about how this problem with SRI has resulted in the traditional definition of SRI – just exclude the sin stocks – changing to including all stocks but “overweighting” those that demonstrate the highest ESG ranking we discussed earlier. This results in a situation where you may pay slightly higher fees but your performance will be about the same as the broader market. That sounds like a more realistic aspiration for SRI funds, and it also meshes well with an excellent paper that RBC Asset Management released which summarizes all the studies performed so far:
Here we see that in nearly all cases, the performance of SRI was the same as the broader market benchmarks, or the differences were considered to be “statistically insignificant”. If SRI manages to match the performance of the broader market, then why not invest responsibly? The only problem remaining is that just a few companies hold all the power when determining who is “good” and who is “bad”. Just how should we define what is good or bad?
When it comes to the environment category, that’s pretty straightforward. You have quantifiable ways to measure adherence to this category such as “carbon units” or “green energy usage”. When it comes to governance, that’s also pretty straightforward. We have courts of law that dictate if a company engages in illegal behaviors like corruption or anti-competitive practices. When it comes to social however, this becomes more vague when we start to talk about things like “human capital development”. Are we going to start using the outrage machine to determine guilt like we do in Silicon Valley now, or are we going to stick to the courts of law that are there for a reason? Will we start enforcing gender quotas like zee Germans or start preaching that meritocracy is a myth like Facebook does? Do investors really think we should be rewarding companies that don’t hire the best person for the job, but use some other criteria instead?
Regardless of whether or not you choose to nitpick the SRI methodology, at a broad level it rewards behavior that the vast majority of society would find to be beneficial. That should be reason enough for you to invest in SRI stocks. There’s a cartoon making the rounds which kind of exemplifies why you should consider SRI investing, and it goes something like this:
The key takeaway here is that whether or not SRI outperforms should be entirely irrelevant. Why does this have to be such a huge selling point? The fact that you are doing good by only investing in socially responsible companies should be reason enough to adopt “impact investing”. If you can achieve the same returns as the broader market then you have nothing to lose. If however, you believe that somehow you’re going to consistently generate alpha over long periods of time from impact investing, then you’re doing it for all the wrong reasons.