The Price Clients Pay for SRI-ESG Investing

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On May 15th, 2017, Larry Swedroe published an interesting article: “The Price Clients Pay for SRI/ESG Investing.”  This blog post will summarize and comment on this article.


Socially responsible investing (SRI) is an investment strategy sometimes referred to as “double bottom line investing” because of its intent to be profitable while also incorporating an investor’s personal values.  SRI often takes the form of negative screening (or excluding) of certain “sin” stocks, such as those which support tobacco, coal, guns, human rights violations, etc.

The article begins by explaining the growth in assets and popularity of SRI. In 2016, US assets under management (AUM) in SRI funds comprised $9 trillion, equating to 22.5% of the overall $40 trillion AUM in the United States. (source: US SIF Foundation)

However, according to the article, SRI clients have given up more than 1% in returns annually.

Moreover, modern portfolio theory implies that the restriction of sin stocks will depress their share prices, because they will trade at a lower Price/Earnings ratio and have a higher cost of capital, thus providing investors in these stocks higher returns.

The Norway Government Pension Fund, benchmarked against the FTSE Global All-Cap Index, is one of the largest SRI investors in the world. The fund, at $870 billion AUM, negatively screens weapons, thermal coal, and tobacco companies. The fund also excludes companies with track records of human rights violations and other corrupt practices. The company that manages the fund’s assets, Norges Bank Investment Management, reported an opportunity cost of 1.1 percentage points that the fund missed out on due to moral stock exclusion over the past eleven years. In other words, if the fund had invested in companies supporting tobacco, weapons, human rights violations, etc. the overall investment return would have been 1.1% points higher.

The Price of Sin

Greg Richey, a Professor in the Finance Department at California State University San Bernardino, studied the “price of sin” from October 1996 to October 2016, tracking whether a portfolio of 61 corporations from “vice” industries outperformed the S&P 500 Index. His findings can be summarized as follows:

  • The “Vice Fund’s” annual return over the 20-year period was 11.5%, as compared to the 7.8% annual return of the S&P 500.
  • All models used (Capital Asset Pricing Model, Fama-French three-factor model, Carhart four-factor model and Fama-French five-factor model) indicated that the “Vice Fund” portfolio beta was between .59 and .74, as compared to the S&P 500 Index, which yields a beta of 1. The difference in betas implies that the Vice Fund exhibited less volatility and market risk over the sample period.
  • The “Vice Fund” outperformed the S&P 500 on a risk-adjusted basis. “Richey concluded that the higher returns of vice stocks were because those corporations’ investments were more profitable and less wasteful than the average corporation.”

The findings of Professor Richey’s 20-year study are consistent with findings from other studies on “sin investments.” Credit Suisse found that over a 115-year period in the United States, (ending in 2014), investment in tobacco companies outperformed the equity market by 4.5 annualized percentage points.

A socially responsible factor model

The commonly used four-factor model measures beta, value, momentum, and size. Two Professors, Meir Statman and Denys Glushkov, took the four-factor model and added two more criteria to create a model that considers the social responsibility factors of companies at stake. The first additional factor was called “top-minus-bottom,” or TMB, which measured employee and community relations, environmental protection, diversity, and products. The second factor was the “accepted-minus-shunned factor” or AMS, which considered the disparity between the returns of “sin stocks” and the returns of stocks that were considered acceptable by socially responsible investors.  Statman and Glushkov then used their model to examine companies over the period of January 1992 to June 2012, uncovering the following:

  • The returns of the top social responsibility stocks were greater than those of the bottom social responsibility stocks.
  • The six factor alpha for the TMB factor was 0.55%, which means that social responsibility leads to enhanced performance when there is high TMB (top-minus-bottom, as defined above). The six factor alpha for the AMS factor (accepted-minus-shunned, as defined above) was -0.36%, which implies that social responsibility, when in the form of high AMS, is a detractor from performance.
  • The returns of accepted stocks were lower than those of shunned stocks.

While the high AMS detracting from performance is to be expected based on the studies mentioned above and additional research, the positive alpha for the TMB factor seems to be an anomaly. However, digging deeper into additional research and other studies, one can see the following:

  • The share prices of companies with highly satisfied employees outperformed those of “regular” stocks (Alex Edmans, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices”, Journal of Financial Economics, 2011)
  • Companies with good environmental records earned higher returns than other stocks (Jeroen Derwall, Nadja Guenster, Rob Bauer, Kees Koedijk, “The Eco-Efficiency Premium Puzzle”, 2005)
  • Stocks of companies that ranked highly on diversity, community/employee relations, human rights, and the environment outperformed stocks that ranked lower on these factors (Alexander Kempf and Peer Osthoff, “The Effect of Socially Responsible Investing on Portfolio Performance, 2007).


The above evidence seems contradictory and, indeed, it is. There are some screens that eliminate sin stocks and lead to lower returns. Yet, there are other screens that provide exposure to factors, such as employee satisfaction and the environment, that lead to higher returns. The takeaway for investors is multifaceted. First and foremost, when deciding how and what to invest in, one must peruse multiple research studies in order to grasp the entire picture. The second key takeaway is that investors should carefully evaluate construction methodology before allocating capital towards an SRI or ESG fund. The third key takeaway is that a trusted wealth manager, like Gitterman Wealth Management, can help you do so.

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