Responsible Investing: Does It Pay to Be "Bad"?
A quick glance at long-term data is enough to conclude: "Sinful" businesses can outperform more responsible investments. However, as a recent Credit Suisse study indicates, "sin" definitely is not the only way forward.
Cinema feeds us with images of Wall Street baddies. We can all remember the infamous "Wall Street" movie character Gordon Gekko, a pop culture symbol of unrestrained greed. But is this the real picture? Does it pay to be bad? In a recent study, Credit Suisse decided to do a reality check to see whether "sin" can pay and how investors can respond to "unacceptable" corporate behavior.
The goal of every investment is usually to make a return. Currently, however, for many investors this is not enough. They want to accumulate wealth in a responsible way and have become increasingly concerned about the social, environmental and ethical issues. Asset managers are therefore expected to demonstrate appropriate investment behavior by taking thoughtful decisions and actions. Naturally, one has to ask: Do the numbers add up?
Vice Vs. Responsible: A Glance at Performance
In the Credit Suisse Global Investment Returns Yearbook 2015, Elroy Dimson, Paul Marsh and Mike Staunton examine the topic of "vice" versus "responsible" investing. The study compares the performance of two contrasting funds: The Vice Fund (recently renamed as the Barrier Fund) and the Vanguard FTSE Social Index Fund. Both are US mutual funds and were launched in the early 2000s. The former invests in businesses considered to be socially questionable: tobacco, alcohol, gaming and defence/aerospace industries. The latter is composed of stocks of companies that have been screened for certain social, human rights and environmental criteria.
Data gathered over a period of nearly 14 years shows that the Vice Fund performed better and is the winner of this comparison (10,000 US dollars growing from inception to 33,655 US dollars at start-2015). Although the Social Index Fund also recorded growth, its rate was lower (10,000 US dollars growing to 26,788 US dollars). The example of the Vice Fund and much of the evidence reviewed by the London Business School researchers suggest that investments in what are considered "unethical" stocks tend to outperform. According to Dan Ahrens, author of "Investing in Vice: The Recession Proof Portfolio of Booze, Bets, Bombs and Butts," the rationale for "vice" investing and its success is that these companies have a steady demand for their goods and services, regardless of economic conditions. They operate globally, tend to be high-margin businesses and they are in industries with high entry barriers.
Just to complete the picture, the researchers reached out to another unsettling study – one that investigates stock markets in countries characterized by corruption. The study concludes that better returns were generated from investments made in the countries generally considered most corrupt.
It may seem surprising, but responsible investors may also contribute to the outperformance of "sin stocks." As Elroy Dimson, Emeritus Professor of Finance, London Business School and Chairman of the Newton Centre for Endowment Asset Management at Cambridge University, indicates: "If a large enough proportion of investors avoids sin businesses, their share prices will be depressed, thereby offering the prospect of elevated returns to those less troubled by ethical considerations."
Tobacco Industry: A Closer Look
To get a long-term perspective at sin stocks' performance, the Credit Suisse study had a closer look at over 100 years of tobacco industry data. It is worth mentioning that tobacco was not considered harmful until the 1950s and, for the first half of the 20th century, the industry's status was neutral. However, once its negative impact became widely recognized, its status shifted from neutral to "sinful" and some investors started rejecting the tobacco business on ethical grounds.
How did this affect the industry's performance? During the transition period, 1947-1965, shares in the tobacco industry underperformed by 3 percent per year in the USA. Still, it was a temporary trend and the decades from the 1960s to the 2000s, when the health impact of tobacco was well known, saw tobacco companies outperforming comparable firms by over +3 percent per year.
The Investors' Dilemma over Exit and Voice
Despite this rather grim picture, there is some good news too. The London Business School researchers have evidence that responsible investing can be fruitful.
For responsible investors, who still have a stake in companies deemed non-ethical, there are two options: "exit" and "voice." Exit, meaning withdrawing from the investment relationship, can relate to companies, industries and even whole markets. This is a very radical step. Investors who choose to exit not only burn their investment bridges, but can also – unintentionally – positively contribute to performance of sin stocks, as described above.
Voice, on the other hand, can be a very powerful tool. Investors can speak out in an attempt to improve corporate behavior. They may hold discussions with executives, send written communications, submit and vote on proxy proposals, and seek to influence regulators and standard setters. The authors of the Credit Suisse study are convinced that: "These activities are undertaken in the belief that responsible investors can guide management toward improved financial performance and/or enhanced social conditions for stakeholders and communities."
The California Public Employees' Retirement System (CalPERS) is an example that has shown that the voice strategy can in many ways be more rewarding than exit. In 2002, CalPERS blacklisted entire countries that fell short of a minimal threshold on factors such as political stability, democratic institutions, transparency, labor practices, corporate responsibility and disclosure. The results were costly: after four years of applying this policy, the losses on its emerging markets portfolio were over 400 mln US dollars. In 2007 CalPERS decided to switch to a principles-based approach and, instead of excluding entire markets, started carefully selecting companies in the developing world. It chose to use voice rather than exit within emerging markets, and embraced dialogue, engagement and shareholder activism.
Doing Well by Doing Good
According to Credit Suisse's report, engagement is not only socially responsible, but has also proven to be profitable. The researchers analyzed the post-engagement performance of investee companies over the course of one year after the engagement.
While it is not surprising that successful actions resulted in material gains (+7.1 percent), the conclusion that unsuccessful engagements did not do any harm to company value is extremely important and encourages responsible investing (they were met with a neutral market reaction).
The gathered evidence shows that responsible investing can pay, but it requires much more effort. If investors want to be rewarded financially, they have to do more than just buy shares in responsibly managed companies. Rather, engagement with the companies whose shares they own or wish to buy seems to be the right course of action. The authors of the Credit Suisse study advise that "to maximize the probability of success, asset owners might consider the 'washing machine' strategy: buying non-responsible companies and turning them into more responsible businesses." After they have been cleaned up, the shares may then be sold at a price that reflects the accomplishments of the activist. While it is not for everyone, such a strategy offers an interesting direction for responsible asset owners.