Socially Irresponsible Investing

Posted on 22/09/2010

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Wikipedia defines socially responsible investing (or “SRI”) as: “an investment strategy which seeks to maximize both financial return and social good. In general, socially responsible investors favour corporate practices that promote environmental stewardship, consumer protection, human rights, and diversity. Some (but not all) avoid businesses involved in alcohol, tobacco, gambling, weapons, the military, pornography, and/or abortion. The areas of concern recognized by the SRI industry can be summarized as environment, social justice, and corporate governance (or “ESG”).”

The importance of SRI has increased dramatically in recent years (by 324% from 1995-2007), with institutional pension schemes – particularly those run for the benefit of public sector employees or with heavy trade union involvement – realising that they can use their power as a shareholder to affect corporate policies in order to implement positive social changes. This report by the European Sustainable Investment Forum found that ~€5tn is now being managed on the basis of SRI principles. These principles work in three major ways: (1) negative screening – the process of excluding companies from the investment universe based on their involvement in certain undesirable sectors or their failure to implement particular SRI policies; (2) shareholder activism – the strategy of using company share ownership as a tool to engage with management, vote-down “unsociable” policies to lead to superior social outcomes; and (3) positive screening – the process of creating an investment universe based on companies that meet certain “socially positive” criteria. The consequences of greater adherence to SRI principles by pension funds should mean that greater amounts of capital flow towards SRI-positive companies, while SRI-negative companies find that their potential investor base shrinks. In turn, a result of this is that “good” companies should experience a lower cost of capital and “bad” companies a higher cost of capital. A working paper  published this month by Sudheer Chava of the College of Management at Georgia Tech shows that this is indeed the case.

Chava’s paper, entitled Socially Responsible Investing and Expected Stock Returns, found that:

investors demand significantly higher expected returns on stocks excluded by environmental screens (such as hazardous chemical, substantial emissions and climate change concerns) widely used by socially responsible investors as compared to firms without these environmental concerns.

Chava goes on to calculate that the cost of capital for firms with environmental concerns is up to 0.8% per annum higher than for firms with no such concerns. It is not just firms with environmental concerns that have a higher cost of capital, those in “sin” industries such as alcohol, tobacco and weapons are also penalised on this basis, as highlighted by Harrison Hong of Princeton University and Marcin Kacperczyk of the University of British Columbia in their paper The Price of Sin: The Effects of Social Norms on Markets.  They conclude that:

Consistent with them facing greater litigation risk and/or being neglected because of social norms, they outperform the market even after accounting for well-known return predictors.

Hong & Kacperczyk found that sin stocks’ cost of equity is approximately 4% per annum higher than the market as a whole.

The conclusion that can be drawn from this is that if the cost of capital is higher for firms operates in “socially irresponsible” industries then the corollary of this is that investors should be able to earn higher returns from investing in such market sectors. Investors can take advantage of this by purchasing an ETF such as USA Mutual’s VICE fund.  The fund has performed very strongly since inception in 2002, as can be seen from the link below, but beware the rather hefty 2% annual fees which will take a big bite out of potential future returns.

VICEX Performance vs S&P500 ETF

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