MNY077: Does Ethical Investing Outperform the Market?

Why ethical investing will underperform the stock market unless consumer behavior changes.

In this episode you’ll learn:

What is ethical investing, also known as ESG or SRI.
How institutions structure ethical portfolios.
How ethical portfolios have performed relative to the overall stock market.
Why should in theory ethical portfolios underperform the overall stock market, absence a change in consumer behavior.
How we can make a larger social impact by what we buy or don’t buy rather than with the investments we choose to own or not to own.
What’s the difference between thick value and thin value.
How can individuals implement ethical (ESG) portfolios.

Show Notes

Responsible Investing – Does It Pay To Be Bad? – Credit Suisse Year Book 2015 – p. 17

The New Capitalist Manifesto: Building A Disruptively Better Business – Umair Haque

Motif Investing $150 Offer

Summary Article

Does Ethical Investing Generate Higher Returns?

As an investment advisor, I had a number of environmental and religious organizations as clients.

These clients had ethical issues with investing in the stock of companies that generated profits in ways that violated these organizations’ moral beliefs or mission.

For larger portfolio allocations, we retained investment managers who could structure a portfolio that avoided holding so called “sin stocks” that were inconsistent with the organizations’ investment policies.

For allocations that were smaller such as to emerging markets or U.S. small capitalization stocks, the clients often didn’t have sufficient assets to meet the account minimums of separate account managers in those areas.

In those situations, we utilized mutual funds, index funds or exchange-traded funds.

The Trade Off

These organizations had to balance their unwillingness to invest in certain untenable securities with their desire to generate the best possible portfolio return in a diversified manner.

They needed to answer the following:

Is it better to achieve a higher portfolio return that allows an organization to do more good in fulfilling its social mission and worry less about whether the portfolio’s securities are aligned with that mission?

Or is it better to accept a lower portfolio return that is generated in a more environmentally or socially responsible manner, but in turn leaves fewer resources for the organization to do good?

Ideally, an organization or an individual wouldn’t need to make that trade-off if socially responsible portfolios outperformed the overall stock market.

Do they? Not necessarily.

Ethical Investing Performance

Absence a change in consumer behavior, returns for so called social responsible portfolios will be lower, although it isn’t as simple as comparing the performance of a portfolio that passes environmental, social and governance (“ESG”) screens with one that doesn’t.

We can go through that exercise though.

For the ten years ending September 30, 2015, the Vanguard FTSE Social Index Fund returned 6.1% annualized versus 7.0% for the S&P 500 Index.

For the fifteen years ending September 30, 2015, the fund returned 2.5% annualized versus 4.1% for the S&P 500 Index.

Meanwhile, the USAMutuals Barrier Fund, which invests in tobacco, alcohol, gaming and weapons/defense stocks, beat both the Vanguard fund and the S&P 500 Index, with a ten year annualized return of 7.1%. That’s after deducting a relatively high 1.4% annual expense ratio.

This suggests portfolios with social, environmental and governance screens underperform both the broad stock market and portfolios with a concentration of “sin” stocks.

The problem with this type of comparison is the performance differential might be due to factors that have nothing to do with the social screens.

For example, the non-ESG portfolio might have a smaller average market capitalization in that its average company size is smaller, and for whatever reason smaller companies outperformed larger companies over the measured period.

It also depends on the time period.

For example, the Vanguard FTSE Social Index Fund outperformed both the S&P 500 Index and the Barrier Fund for the three and five years periods ending September 30, 2015.

Why Ethical Investing Underperforms

So if the historical record is mixed regarding the outperformance of ESG portfolios, how can I say ESG portfolios will underperform non-ESG portfolios over the long-term if consumer behavior stays the same?

Because that is how the investment math works.

If there is a large contingency of investors who refuse to invest in the stock of vice companies or companies who are less environmentally friendly, then those stocks will be less in demand and consequently will sell at lower valuations compared to their non-vice, more environmentally friendly counterparts.

A lower valuation means stocks that don’t pass ESG screens will have higher dividend yields.

A higher dividend yield allows investors to receive more dividends per dollar invested, resulting in better performance compared to stocks with lower dividend yields even if valuations don’t change over time.

As long as there is growing demand for the products and services of companies with poor environmental, social or governance records, then their stocks will outperform their more socially responsible competitors.

Consequently, the primary way consumers can impact the stock performance of companies who don’t meet their environmental, social and governance standards is to stop buying the companies’ products or services. Instead, they should buy from companies who meet those standards.

If a large enough group joins them in boycotting the particular product or service, it will impact those companies’ revenues, earnings and ultimately their stock price.

Through our purchase decisions and our communication with companies directly or via social networks, we can help them realize that it isn’t enough to pursue initiatives and launch products where the expected return exceeds the company’s financial cost of capital.

Rather, companies should factor in the full spectrum of capital costs including human, social and environmental costs.

Thin and Thick Value

Umair Haque in his book the New Capitalist Manifesto labels companies who generate profits by simply exceeding their financial cost of capital as creating “thin value”.

Thin value might look good on a financial statement or spreadsheet, but it does so as Haque describes by shifting costs or borrowing benefits from people, communities, society, the natural world or future generations.

Instead, companies should create what Haque calls “thick value.” Thick value is created when companies “create profits by activities whose benefits accrue sustainably, authentically, and meaningfully to people, communities, society, the natural world and future generations.”

Just recently, we saw how Volkswagen created thin value by rigging their diesel engines to operate in a more environmental fashion during emissions tests.

Yes, that boosted VW’s financial profits for a time. Now that their deception has been found out, not only has VW’s stock fallen over 40%, but the company’s very existence is at stake.

What Volkswagen did was illegal, but there are many ways corporations can create “thin value” legally.

As consumers, we should hold companies to a higher standard, first through our purchase decisions and eventually through our investment choices.