SRI Notes

Financial Analysts Journal on the Eco-Efficiency Premium

posted by Jeff MacDonagh

I was pleasantly surprised to see FAJ publish this piece on the portfolio management implications (via backtesting) of using Innovest ratings.  "The Eco-Efficiency Premium Puzzle" (Derwall, Guenster, Bauer, and Koedijk) is another decent article to contribute to our growing body of literature showing the legitimacy of using non-traditional data in stock picking.  Moreover, I think the authors are correct is raising the possibility of "mispricing" based on the degree of outperformance and their use of a multifactor model to control for several traditional financial factors.

Here's the abstract:

Does socially responsible investing (SRI) lead to inferior or superior portfolio performance? This study focused on the concept of "eco-efficiency," which can be thought of as the economic value a company creates relative to the waste it generates, and found that SRI produced superior performance. Based on Innovest Strategic Value Advisors' corporate eco-efficiency scores, the study constructed and evaluated two equity portfolios that differed in eco-efficiency. The high-ranked portfolio provided substantially higher average returns than its low-ranked counterpart over the 1995–2003 period. This performance differential could not be explained by differences in market sensitivity, investment style, or industry-specific factors. Moreover, the results remained significant for all levels of transaction costs, suggesting that the incremental benefits of SRI can be substantial.

Recommended

Not really a secret as it moves up the best-seller lists, but Freakonomics deserves the praise it's received. At least two chapters - one on the finances of a Chicago crack gang, the other an account of the rise and fall of the Ku Klux Klan - could be books themselves.

The praise is not unanimous.  Some economists have criticized Levitt's methods as imprecise or worse.  Salon complains that he doesn't offer solutions to the problems he identifies.  For my own part, I can't say I'm comfortable with the breathless attempts to turn him into a celebrity.  And the title is...not good.

But Levitt's work is very important to social investing. Several of his studies demonstrate that cheating pays in some professions. And he has pioneered analytical techniques (mainly of question framing) that make it possible to detect cheaters in situations you might not have expected. Social investors would do well to borrow some of those tricks.

And yes, there is a blog.  Levitt and co-author Dubner helpfully give a list of their negative reviews here.

An Exchange

 

Dear Sir,

I read your entry “Nice update on the performance debate” in your SRI blog. One comment to your reasoning for why there will never be a final answer to whether SRI outperforms the overall market:

 

Isn't there a possibility that as we speak (or some time in the future) when investors observe the potential gain from investing in social responsible firms they will invest to the degree where the social responsible firms only generate an average profit.

 

 

I would draw the comparison to the diminishing "January-effect" we've seen in financial markets lately. Could investors learn about the SRI effect the same way, and in turn, make future SRI-studies show no superprofit for social responsible firms?

 

 

Vegard Vik

Student,

Norwegian

 

School

of Economics and Business  Adm.

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Hi there, I personally believe that the effect you suggest has already happened to some degree. If there were a consistent, reliable SRI effect, it would almost certainly attract the attention of investors. With large mutual funds and even SRI hedge funds out there, it's hard to argue that no one in markets is paying attention to this possibility. There is a little hard evidence that investors are bidding up socially responsible stocks. If you look at Marc Orlitzky's study, you'll see that social responsibility correlated more strongly with accounting-based measures of performance than with market-based measures. That strongly implies that the market is already discounting some of the benefit of social responsibility by corporations.  Dowell, Hart and Yeung also show evidence that environmental policies are incorporated into the structure of global price/book ratios. If that's right, it means the market is already bidding up stocks likely to have superior environmental performance. Investors buying those stocks at higher valuations, anticipating an environmental return, may be disappointed. One final thought. 15 years ago, when we started the Domini Social Index, I ran an analysis showing that its P/E was attractive relative to its reinvestment rate when compared with the S&P (you can find the math in Chapter #25 of The Social Investment Almanac).  If you repeat that same analysis today, the Domini Social Index does not have the same advantage. So the idea that there was a positive effect, but investors have caught on to it, is not unfounded. Hope that's helpful. - LK

 

The Energy Problem

Over the past eighteen months, energy stocks have taken over the market. Here is a chart of the performance of the Amex Oil Index vs. the S&P 500:

Not coincidentally, several social indexes have lagged the S&P 500 over this period. The broad-based social indexes typically hold 1-3% of their investments in energy stocks, far less than the 7% or so held by the S&P 500.

The oil sensitivity of the social indexes has not been a secret - Dan Dibartolomeo and I wrote about it in a Journal of Investing article in 1996. But in those days the energy sector was delivering indifferent performance, giving social indexes a performance boost.   Today that dynamic is working in reverse.

An analyst at Goldman Sachs has famously predicted that oil could reach $105 a barrel.  Performance-minded investors in social indexes should hope it doesn't.  But isn't that a little odd? From an environmental perspective, higher oil prices would probably be beneficial: expensive energy encourages conservation and the development of alternative fuels.

This is one instance where active investors may have an advantage over passive ones. An active manager can choose to manage this risk by buying more energy stocks - an unmanaged index can't.