Socially Responsible Investing: What About Expected Returns?Murray Coleman
Thursday, January 23, 2020
When socially responsible investing funds first started dribbling onto the market, many fund analysts warned that such restrictions would limit index construction and lower expected long-term returns.
Fast-forward a few decades and hundreds of socially responsible investing (SRI) mutual funds are available to mom-and-pop investors. The industry has been so prolific that the field has been marketed in multiple forms. Although various flavors and specialties can be applied by discerning investors, these generic SRI strategies can also fall under markings including: Environmental, Social and Governance (ESG); sustainable investing; impact investing, clean-tech and green funds.
The abundance of such funds has translated into exposure to nearly every asset class and global market. This raises an important question for those who don't want to invest in companies like gun makers, brewers of alcoholic beverages or environmental polluters: Are expected returns for "socially responsible" strategies lower compared to a more conventional approach?
No matter what nomenclature is used -- be it ESG or SRI -- our portfolio management and research team applies an efficient frontier analysis to the fund. This means any gains are judged relative to how much market risk is being injected into a portfolio. Without such a risk-adjusted review, leading academics including Eugene Fama, Kenneth French and Harry Markowitz have raised red flags about the dangers of chasing performance based solely on raw returns.
Long before SRI investing became so popular, professors Fama and French actually tackled such a question in their 2005 quintessential research piece, "Disagreements, Tastes, and Asset Pricing."1
Along these lines, it's probably worth noting their 2011 posting on the topic on the Fama/French Forum:
"Like all prices, asset prices are determined by supply and demand. If some investors overweight the stocks of "socially responsible" firms, they push up prices and reduce expected returns. Similarly, they push down the prices and push up the expected returns of the socially irresponsible firms they underweight. Presumably that is their goal—to reduce the cost of capital of firms they like by reducing the "good" firms' expected stock returns and to increase the cost of capital of firms they don't like by increasing the "bad" firms' expected stock returns."
Fama and French go on to add:
"These changes in expected returns induce other investors to underweight the "good" firms and to overweight the "bad" firms. Socially responsible investing has not been around long enough to measure the magnitude of these effects. We can be sure, however, that if socially responsible investors have any real impact, they push down the expected return on the stocks they overweight and increase the expected return on the stocks they underweight."
According to The Forum for Sustainable and Responsible Investment (U.S. SIF), as of year-end 2018, more than one-out-of-every four dollars under professional management in the U.S. -- or, about $12 trillion -- was invested according to SRI strategies.2
Such a growing presence of SRI investing raises another question: Are these numbers large enough to have the impact on prices and returns that Fama and French discussed above?
We are skeptical. According to the U.S. SIF Foundation's most recent annual report, the pie of total assets under professional management in the U.S. is more than $46 trillion.3 As long as a significant amount of investment dollars is engaged in rational pricing activities, then we can safely assume that both the securities that qualify for SRI strategies and those that do not are fairly priced.
The academic evidence gives us confidence that it's entirely possible to do well while doing good.
We urge anyone interested in taking advantage of globally diversified and passively managed SRI investing strategies to check with Mary Brunson, vice president of Investing for Catholics, a unit of Index Fund Advisors. Please feel free to call her at: (888) 815-5025. She can also be reached through email: firstname.lastname@example.org
1.) Eugene Fama and Kenneth French, "Disagreements, Tastes, and Asset Pricing," Nov. 17, 2005.
2.) The Forum for Sustainable and Responsible Investment, "2018 Report on US Sustainable, Responsible and Impact Investing Trends," Oct. 31, 2018.
3.) The Forum for Sustainable and Responsible Investment, "2018 Report on US Sustainable, Responsible and Impact Investing Trends," Oct. 31, 2018.
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