February 9, 2016
Mirror, Mirror on the Wall: Virtue or Vice?
Please read important disclosures HERE.
February 9, 2016
Please read important disclosures HERE.
“I’m not good, I’m not nice, I’m just right…” The Witch (Into the Woods)
There has been increasing media and academic coverage on socially responsible, sustainable and all varieties of mission- or value-based investing strategies. These strategies, collectively referred to in this article as “sustainable investments,” generally incorporate environmental, social and/or governance (ESG) factors in investment (or divestment) decisions. From an investment perspective, does it pay to be good? Or, does being bad, or taking the good with the bad, offer a better economic outcome? What is the right approach, all things considered?
Dan Aherns argues in his book, Investing In Vice: The Recession-Proof Portfolio of Booze, Bets, Bombs, and Butts, that people will continue to indulge in alcohol, adult entertainment, and gambling, and to engage in wars even in the worst of times. By extension, a portfolio concentrated in these so-called sin stocks should be a winning strategy. Economists at the London Business School also reported last year that the best-performing industry in the U.S. since 1900 was tobacco, returning 14.6% annually to investors versus 9.6% for the overall stock market (alcohol was also the best performing industry in the U.K. during the same period).
One reason for the success of sin stocks over this time might be that they became cheaper as mainstream investors sold or avoided them for non-financial reasons, perversely increasing the probability that these stocks would outperform. For investors whose primary goal is profit maximization, exploiting this “sin premium” and exchanging a diversified portfolio for a basket of sin stocks might seem appealing. However, secular trends in the industry, general shifts in attitudes toward environmental stewardship, and corporate and social responsibility among investors as well as governments, may make one think twice about such a move. Take coal, widely considered the dirtiest fuel source. The Dow Jones U.S. Coal Index (an index of the stock of coal producers) has dropped over 90% since 2011. Coal companies have battled the decline in coal prices due to weaker energy prices and a switch to other energy sources, particularly natural gas. Further, in the last couple of years, coal producers have endured the divestment of coal-related investments by some of the world’s largest investors such as the California Public Employees’ Retirement System (CalPERS) and the Norwegian Sovereign Wealth Fund. While coal mining stocks might seem like a bargain now, they are quite risky. In fact, some of these companies have already declared bankruptcy.
The prevailing investment view has been that investors are most likely to achieve the highest risk-adjusted returns when they can access the widest opportunity set of investments, unfettered by environmental and social concerns. Low-cost investing with broad diversification will likely continue to be appropriate for the majority of investors.
Sustainable investment is nonetheless the fasting growing segment of the asset management business. According to the Global Sustainable Investment Alliance, the sustainable investment market worldwide jumped over 60% from $13.3 trillion in 2012 to $21.4 trillion in 2014. There is also a growing chorus of reports and studies published by the likes of Harvard Business School1 , Oxford University2 and various investment management firms that support the view that one need not give up financial returns to do good.
One investment firm that appears to have incorporated the sustainable approach successfully is former U.S. Vice President Al Gore’s Generation Investment Management. A recent article in The Atlantic3 reveals that Generation’s global equity fund generated an annual return of slightly over 12% in the past decade, handily beating the average annual return of the MSCI World Index by 5% during the same period. The Generation fund takes a “holistic” view of investing by selecting companies based not just on traditional profitability and valuation metrics but also on long-term ESG factors.
Generation’s global equity fund targets large institutional investors and is now closed to new investors. However, over the past several years, fund companies, large and small, have introduced many new sustainable funds accessible to private investors. The challenge, however, is that many of these funds have shorter track records and frequently carry higher costs. Similar to traditional investment funds, there are also wide dispersions of returns and volatilities across different sustainable funds. Funds with more concentrated holdings and fewer positions typically have more significant performance deviation (positive or negative) from broad market indexes.
More importantly, sustainable funds come in many different flavors and may employ different ESG definitions as well as investment selection methods. Some of these funds focus on excluding offenders while others overweight companies that score high on ESG factors. Without understanding each fund’s specific approach, an investor may be surprised to learn that the composition of a particular sustainable fund may not align with his or her objectives. For instance, Apple is included in some sustainable funds for scoring high on environmental stewardship but is excluded by others because of their labor practices. Some sustainable funds may even include the stocks of large oil producers, although in smaller amounts than the broad market.
Implementing a sustainable investment strategy can be complex as it requires understanding each individual’s financial and ESG goals and matching those with the appropriate investment vehicles. The B|O|S research team has continued to follow the development of the sustainable investment landscape and available investment options. We generally prefer funds that are liquid, diversified, and low-cost with a reasonably long track record. TIAA-CREF and Vanguard offer some good options and there are others. More customizable solutions are available to investors with larger portfolios. We will discuss specific sustainable investment options in greater detail in an upcoming newsletter.
1“The Impact of Corporate Sustainability on Organizational Process and Performance” by Eccles, Loannou & Serafeim – Harvard Business School, November 14, 2011.
2“From the Stockholder to the Stakeholder: How Sustainability can Drive Financial Outperformance”, Clark & Viehs – University of Oxford, Feiner – Arabesque Asset Management, March 2015.
3“The Planet-Saving Capitalism – Subverting, Surprisingly Lucrative Investment Secrets of Al Gore”, The Atlantic, Fallows, November 2015.