Does Socially Responsible Investing Work?

I admire people who don’t set ethics aside when they invest. That said, the conversation about what you would give up in the pursuit of socially responsible gains must be fully acknowledged. There has been a recent trend among financial professionals to downplay the performance sacrifices that occur when you decide to make an investment in a socially responsible fund. This is ironic that someone peddling socially responsible investing would start off the conversation with a lie, but it also provides disutility down the road when someone investing in a socially responsible mutual fund finds himself reaping returns that are lower than he is led to believe.

The impetus for my article is a comment from Morningstar analyst David Kathman, who said in a Kiplinger interview that: “There is no evidence that shows ESG or socially responsible investing helps or hurts performance. Over the long term, it probably evens out.”

That is a junk observation that has no connection reality. From 1900 through 2012, tobacco stocks delivered annual returns of 19.7%. Most socially responsible funds exclude them. From the end of WWII through 2012, alcohol stocks delivered returns of 11.5%. Most socially responsible funds exclude them. Since the creation of The Standard Oil Trust in 1882, the average integrated oil company has delivered 12% annual returns. Some socially responsible funds exclude them. A corporation like Church & Dwight, which own Trojan condoms and are excluded from some socially responsible funds, has returned 17% annually since its January 1978 IPO.

If you remove tobacco, alcohol, and energy from the U.S. stock market from 1926 through 2012, those 10% annual returns that you hear about become 7% annual returns instead. Over a half-century long investing life, the difference between 7% and 10% is the difference between a terminal value of $327,000 and $1.4 million. To me, those are insanely substantial costs. It is not something I would, in any way, describe as something that “probably evens out” over a long period of time. For every fifty-year holding period, the costs of socially responsible investing means sacrificing capital appreciation that is over 100x greater than the initial amount that you invest.

Over the past ten years, the socially responsible fund benchmark has returned 6.5%. That’s about what you would expect to see once you remove the high performance of many corporations that are excluded due to the perception that they are immoral.

Personally, I think some socially responsible investing is the result of a misguided do-gooder impulse. If you buy a share of Brown Forman (BF.A) on the New York Stock Exchange, you aren’t facilitating additional production of hard liquor. You are buying a one share claim out of the 388,888,837 shares that already exist. Now, if there is a capital raising event in which Brown Forman issues new shares to fund growth, then you can argue that your contribution is furthering the expansion of alcohol sales and it would be immoral to participate because you are spreading the ill effects of alcoholism. But if you buy a pre-existing share on an exchange, you are just swapping ownership positions with another investor are not doing anything that actually enables Brown Forman to sell more alcohol.

Secondly, it is the owners of the corporation that have the most direct ability to bring about positive change. If you refuse to own any shares of a company you morally despise, you are relinquishing a direct claim to affect the culture/morals of the business. If you buy shares of a tobacco company, you can vote on shareholder initiatives that aim to curb the effects of nicotine addiction. Someone that owns 20,000,000 shares of Brown Forman that wants to launch an anti-drunk driving campaign is going to have a much greater ability of realizing that ambition than someone that tweets in favor of safe driving.

Over very long periods of time, the center of gravity for socially responsible funds seems to be in the 6-7% range. Meanwhile, someone who invests without constraint is making investments with a center point of 9-10% returns. You are looking at about a three percentage point annual forfeiture when you invest in socially responsible investing. It is a hurdle—some excellent fund-managers might be able to bridge this difference. Maybe that cost is worth it to you. But it is tradeoff decision you should make with eyes wide open about the pros and cons, and you should not heed the advice of those who claim that socially responsible investing does not come attached to a likelihood of lower wealth accumulation.

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