SRI Notes

Vice is Nice, but Not Indispensable

I've had some questions about this December 14th press release from QED International, which states that social investors' aversion to vice industries has cost them returns.  I'll start with my critical remarks, but I also have some positive comments (down near the bottom).

Any time I hear about a study of historical returns, I have some basic questions:

Question 1:  Can I see the study?
Answer:  In this case the press release appears to be the study - there's no information on how to get a more detailed look at the work.
LK Comment:  There is a often a big gap between what the data shows and what the authors say it shows - if there's an underlying study it's good to have it.  In this case we'll work from the press release, which is pretty detailed.

Question 2:  Has the study been reviewed by anyone else or is it likely to be published somewhere?
Answer:  There's no mention of a more thorough writeup, nor of any attempt to have the work reviewed or published somewhere.  That doesn't mean it won't be, they just aren't telling you in the press release.
LK Comment:  It's a lot easier to write a press release than to publish an article in a refereed journal.

Question 3:  Does the study look at real portfolios, or backtests?
Answer:  Backtests (with the exception of Domini Index/ S&P 500 comparison).
LK Comment:  Hindsight is 20-20 - at any moment in time you can pick a group of stocks excluded by social investors that has performed well, and write an article about how social screens are costing investors money.  (For some reason everyone wants to talk about tobacco lately but not about the auto companies, which social investors have also avoided and which have underperformed badly in recent years.)

  Anyway, the real test of an investment strategy is whether it works forwards, not backwards.  The only analysis in the press release I could call prospective is the table at the bottom of page three.  It shows their vice composite with a marginally higher estimated growth rate than the Value Line universe (9.7% vs. 9.3%), and slightly more attractive valuation ratios.  Okay, that's a good point.  Vice stocks are expected to grow a bit faster and look to be a little cheaper.

Question 4:  Do the numbers look ok?
Answer:  No.
LK Comment:  The table at the top of page 2 presenting Domini Social Index vs. the S&P 500 appears to be in error.  It shows the Domini underperforming the S&P 500 for the 10 years ended September 30th, when KLD's 9/30 press release shows outperformance during that period.  They show the Domini Social Index for the 10 years at an annualized 8.74%, while KLD reports 9.97%.  I don't know, but I'll bet they used the Domini Social Equity Fund's performance instead of the underlying Domini Social Index, comparing a mutual fund with expenses to an index which has none.

  The QED press release claims the Domini Social Index is behind the S&P "for annualized periods of one, three, five, and ten years."  But comparing index-to-index using KLD's reported returns, it looks like Domini is ahead on its ten-year record, about tied on its five-year record, and behind over just the past one- and three-year periods.

Question 5:  Are returns risk-adjusted or presented in the context of a risk model?
Answer:  No.
LK Comment: Sometimes a study shows a significant performance difference between portfolios, but does not explain where the difference might come from.  In fact, there's a well-developed literature on determinants of differences in portfolio return.  The usual suspects are:

• Risk (beta)
• Size (market capitalization)
• Valuation (price/book ratio)
• Momentum (relative price strength)

Usually, these factors explain most of the differences in historical investment performance among portfolios.  If you use the variables listed above you're using a Carhart model, if you drop momentum you're using a Fama & French model.  The authors of this press release appear to have used neither.

And that's a problem.  Their argument is:  the Domini Social Index left returns on the table - given the data problems it is clearly not true for all the time periods they list, but it certainly has been true over the past one and three years.  The authors would like to show that this shortfall was because of the failure to own vice stocks.

But maybe it was just a failure to own value stocks or small stocks, both of which have had great performance lately.   The authors include some commentary on this, but without a risk model we can't know the answer with any precision.  And it's really important to know that answer:  if the Domini Social Index is underperforming because it doesn't own value stocks, that's a solvable problem (investors can supplement it with a value fund, or pursue other diversification strategies).  But if there's something really special about vice stocks, that makes it impossible to create diversified portfolios without them - well, that would be big news, and a big problem for social investors.

So those would be my questions, and after looking at the press release they haven't persuaded me.  To show that social investors are making a BIG MISTAKE by not owning vice stocks, they need to show that that excluding them creates unavoidable diversification costs.  And I'm not seeing it here.  From that perspective I'm a lot more concerned about Energy than the sectors they presented in this study.

Let me finish with a positive comment.  In addition to their retrospective analysis, the authors do some APT analysis of the excluded sectors (there is a good explanation of APT here).  This is new and useful work and deserves attention - I have not seen APT analysis of specific excluded sectors before.  Dan Dibartolomeo and I did an overall APT analysis of the Domini Social Index ten years ago (we used a different model than the one used here) and found that its macroeconomic bets differed significantly from the S&P 500 (see Kurtz,  Lloyd and Dan DiBartolomeo, "Socially Screened Portfolios: An Attribution  Analysis of Relative Performance." Journal of Investing, Fall 1996).  Dan updated this work in 1999 and that paper ("Managing Risk Exposures of Socially Screened Accounts") is available on the Northfield website.  Our analysis suggested the Domini index was particularly oil price-sensitive, and could underperform during a period of rising oil prices.  And we have certainly seen that.

Hopefully QED will follow this up with a more detailed white paper, or better, a journal article.  I think the APT aspect of this work could be a journal article in itself, particularly if the authors computed the APT coefficients for the Vice Composite they present on page three.

James Hoopes Comments

Jim Hoopes of Babson College, who teaches both History and Business Ethics, offers some additional comments on Economic Man:

"The idea of rational economic man acting out of his self interest is often mistakenly attributed to Adam Smith and that wonderful 18th-century conception of a moral paradox in human society that allows private vices to become public virtues.  So self-interest or, as I believe Smith called it, self-regard leads to the wealth of nations.

"There's a passage in Smith's Wealth of Nations that touches on this:

It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their humanity but to their self love, and never talk to them of our own necessities but of their advantages.

"What gets forgotten is that contrary to what one might think from the quote, Smith did not dispute the existence of "benevolence" but thought it a real force in human affairs as he made clear in his Theory of Moral Sentiments.  In fact it was because of the limitations placed on the behavior of most people by their sentiment of benevolence that Smith believed freedom (including free markets) was morally justifiable.

"People on average could be counted on not to be governed solely by self-regard and not to indulge in the utter ruthlessness that would result from single-minded attention to self-interest.  Were it not for the sentiment of benevolence a moral society could not tolerate freedom but would require authoritarian princes, priests, etc."

Some Notes on Altruism at Year-End

In the spirit of the season (isn't it interesting that the biggest month in retail is driven by people buying things for other people?), here are some notes on altruism.

Altruism and Economic Man

The most persistent ideological argument against social investing is that altruism has no place in economic life.  Society will work best, according to this argument, when everyone acts soley in their own economic self-interest.  Leaving aside the question of whether you can be an altruist when you're not giving up returns (the historical experience of social investors), this boils down to a defense of Economic Man, the classical economic view of humans as self-interested profit-maximizers.

Social investors risk wasting time and resources responding to this argument in all its forms - no matter how many times it is answered there will always be someone paid to make it one more time.  But it is worth noting that Economic Man has plenty of respectable enemies, from Keynes to Richard Thaler to the Austrian School.

An economic defense of social investing must be based on the idea that Economic Man is seriously incomplete.  This is true on at least three levels:

• It is incomplete as an explanatory concept because people don't behave rationally - they misjudge risk, they buy lottery tickets, they pay high premiums for small marginal gains in convenience - so a model assuming rational behavior is bound to produce disappointing results.
• It is incomplete as an investment approach because Economic Man doesn't have to deal with the emotional implications of his decisions.  As markets become more efficient it is likely that successful investment strategies will entail considerable psychological costs.  For a hugely entertaining riff on this theme in the investment world see Malcolm Gladwell's brilliant New Yorker article on Nassim Taleb, or better yet, read Taleb's book, Fooled by Randomness, in which he described the excruciating psychological pain of his winning investment strategy.
  
• Most importantly, it is incomplete because Economic Man is not cognizant of the environmental impacts of his decisions.  Economic Man seeks the highest return, but no rational person would accept a high return on investment if it meant permanent severe damage to his health and wellbeing.  Let's say it's 100 years from now and there's no potable water in the state of California.  Their first question about us is not going to be "did they seek the highest possible investment returns?"
  

Altruism and Evolution

In an earlier post I mentioned that experiments in game theory have not found altruism to be a successful strategy, raising a serious intellectual challenge to those who practice it (game theory is basically Economic Man on steroids).  In trying to formulate a response I turned to evolutionary theory (which is arguably game theory on steroids).

The final chapter of Ernst Mayr's This is Biology asks "how could any ethics develop [from evolution] that is based on altruism and on a sense of responsibility for the welfare of the community as a whole?"  Mayr, who passed away earlier this year, says "my own values are rather close to Julian Huxley's evolutionary humanism.  'It is a belief in mankind, a feeling of solidarity with mankind, and a loyalty toward mankind.  Man is the result of millions of years of evolution, and our most basic ethical principle should be to do everything toward enhancing the future of mankind.  All other ethical norms can be derived from this baseline.'  Evolutionary humanism is a demanding ethics, because it tells every individual that somehow he or she shares a repsonsibility for the future of our species, and that this responsibility for the larger group should be just as much a part of cultural ethics as concern for the individual."

For the truly committed, there is Elliot Sober and David Sloan Wilson's Unto Others:  The Evolution and Psychology of Unselfish Behavior, who argue that "the case against evolutionary altruism has already crumbled when judged by normal scientific criteria."  This is a hard book, but I think an important one for people who are trying to think clearly about these things.

There is an article on biological altruism in the Stanford Encyclopedia of Philosophy, here.

So what should we do?  Enjoy the holidays!  We'll come back next year and figure all this stuff out.

If you are feeling altruistic and would like to get some additional deductions before AMT sets in next year, here are some places where your donation would be likely to have a significant lasting impact:

• Accion International - Microloans to entrepreneurs around the world
• Ashoka - Venture capital for the bottom of the pyramid
• Heifer International - Provides livestock and training in organic farming