Does socially responsible investing (SRI) sacrifice investment returns to principles? The answer is no, according to studies published in peer-reviewed journals and elsewhere. The majority of the more than 50 studies on SRI performance find that the socially-aware approach fares just as well as non-SRI approaches.
Reinforcing this conclusion are the track records of stock market indexes made up of companies screened by environmental, social and governance (ESG) criteria. The MSCI KLD 400 Social Index (DSI), previously known as the Domini 400 Social Index, saw an annualized rate of return of 7.64% over the last 10 years through May 2017, compared to 4.87% for the Standard & Poor’s 500 Index over the same period. Over the last 5 years, the KLD saw returns of 13.05%, while the S&P 500 saw returns of 11.27%.
Some people might think an SRI should underperform because it places additional constraints on portfolio managers. It rules out companies that sell addictive or harmful products such as tobacco, alcohol, pornography, gambling games or weaponry. And it directs investors to buy stakes in companies that: i) preserve the environment; ii) practice good employee relations; iii) do not violate human rights; iv) adhere to good governance; v) are sensitive to indigenous peoples; and/or vi) enjoy good relations with their communities.
These extra ESG requirements leave a smaller universe of equities from which to choose. In particular, the absence of stocks from the noncyclical sectors of tobacco, alcohol and gambling can punish relative performance during bear markets. Moreover, ESG-compliant companies may forgo profit opportunities (e.g. not mining in an area where environmental concerns exist) or incur extra costs (e.g. operating advanced pollution-remediation technologies), whereas non-ESG companies might create more profit by doing the opposite.
However, there are offsets. ESG screens tend to filter in more small cap and economically-sensitive stocks. Small caps, according to the Fama and French three-factor model, have historically outperformed the broad market by a significant margin. Cyclical stocks tend to boost returns during bull markets and allow SRIs to catch up from any underperformance caused by not buying into tobacco, alcohol and gambling industries during bear markets.
Socially responsible companies also face fewer of the costs and risks associated with class-action lawsuits, consumer boycotts, unfavorable government rulings or legislation and other risks arising from socially irresponsible actions. These are contingencies that usually don’t show up in financial statements, yet they have the capacity to inflict sudden and dramatic setbacks in cost structures and profit opportunities – for example, if a court awards substantial compensation to plaintiffs or the government issues an edict imposing stricter emission controls.
Profit in Focus
Yet another reason why SRI doesn’t have a negative impact on investment performance is that money managers at SRI-focused financial institutions usually blend ESG selection rules with portfolio-management precepts. For example, to build a diversified portfolio, managers may stratify the stock population by sectors and pick the ESG companies best able to represent those sectors. This can make an SRI portfolio look more like a non-SRI portfolio.
Some SRI practitioners place less emphasis on negative screening (excluding bad companies) and more on positive screening and “engagement” (accepting less-than-perfect companies and using shareholder advocacy to campaign for further improvement). Again, this may result in less divergence between SRI and non-SRI portfolios in terms of appearance and performance.
Studies find wide dispersion in returns across SRI mutual funds. For example, research by London-based Jewson Associates notes that SRI mutual funds in the U.K. earned a range of returns between 10% and 29% in the last year of the coverage period. This range reflected differences in ESG screens; some SRI funds exclude only flagrant breeches of social responsibility, screening out just 2% to 3% of the market, while other funds are more stringent, screening out up to two-thirds of the market.
The Bottom Line
Long-term investors do not appear to need sin stocks or other ethically questionable investments in their portfolios in order to achieve acceptable returns. Furthermore, SRI can be used as a risk reduction technique because it weeds out socially irresponsible companies, which tend to be more exposed to reversals emanating from lawsuits, boycotts, changes in government regulations/legislation and similar liabilities implicit in irresponsible behavior. It seems you can make socially responsible choices and still come out ahead.