SRI Notes

Are We Unsound? Another Analogy

Due to the emergence of new commitments and the growth of old ones, I am making my final posts to this blog in August/September 2008.  This is the second of two brief essays on the philosophical justification for social investing.

In my first note on this topic, I compared social investing to the Latvian Gambit, a popular but probably unsound chess opening.  In this essay I'll draw another, more hopeful analogy.

I guess I should acknowledge that my motivation for elaborating on this theme is partly emotional.  On the rare occasions when I've met genuinely influential people, or apparently skilled investors, their interest in social investing has been minimal.  Sometimes their reaction verges on pity, or disappointment that I would waste a lot of time on this. 

I hate that.

I should hasten to add that these people are almost never rude.  They're not trying to be oppositional or patronizing.  It's just that powerful and accomplished people generally think the world's a pretty tough place, and good intentions don't get you very far.  Warren Buffet once told journalist Marc Gunther "I've seen a lot of not-very-good people succeed in business...  I wish it were otherwise."

Well, let me propose another analogy.  I do believe there is another way of looking at this, which casts social investors in a potentially more important - even critical - role.

In the early 1920s a group of chess players emerged who became known as The Hypermoderns.  They played weird openings - things that had not been seen much before, and which appeared to the chess orthodoxy to be as unsound as the Latvian.  They had their victories and defeats.  None of them ever became champion (although some champions were deeply influenced by them), but many of the strange openings they played turned out to be pretty good.  Some of those openings became standard issue for up-and-coming masters.  Ultimately hypermodern openings played a significant role at the top level of play - from Anatoly Karpov's frequent use of the Queen's Indian Defense, to Bobby Fischer's surprise deployment of Alekhine's Defense in his match with Spassky.

The point is that the initial reception to an intellectual innovation tells you nothing about its ultimate validity.  The greatest chess players in the world thought Alekhine's Defense was a bad idea when it was first played.  A generation later, the greatest chess player in the world used it successfully in the most important match of his life. 

This is the norm.  In any field of intellectual endeavor, but especially in competitive ones, new ideas arise, are dismissed, are fought over, and ultimately, if they are valid, become a part of the orthodoxy. 

This doesn't mean that social investors are right, but it does mean they should investigate and develop their theories.  They can certainly expect opposition and indifference, and they will likely meet with these regardless of the validity of their claims.  Bill James, the man largely responsible for the modern revolution in baseball analysis, once wrote something to the effect that "if I have to play Galileo...[someone else] has to play Pope."  Which was probably true, but also hints at some of the psychological pitfalls faced by the innovator. 

So, if the opinions of even brilliant theorists and practitioners are not a reliable guide as to the validity of social investing, what might be?  I'll offer two answers - one empirical and one analytical.

First, from an empirical perspective, we have plenty of performance and market share data now.  The social indexes and mutual funds have been closely studied for many years, and their performance has been competitive.  And, as the Social Investment Forum's Trends report shows, social investment products have taken share over the years.  Any investment style can generate performance and win share over a brief time, but social investing has been operating and growing in influence since the 70s, in every imaginable market environment.  To return to our earlier analogy, that seems to fit the experience of the Hypermoderns more than it does the Latvian.

But why should we expect our success to continue?  What, apart from performance and market share numbers, can we look at when we assess the advisability of social investing?

My analytical answer is as follows:  When you look at the history of any intellectual endeavor, it is striking how many big discoveries, at any moment up to the very recent past, had not yet been made.  We are accustomed to thinking of ourselves as living in "modern times" and we think of our knowledge as pretty complete.  But it ain't. 

Just think of the advances in medical treatments over the past generation.  Here is a picture from the 1968 movie Bullitt, which was partly filmed on location in a San Francisco hospital, with real doctors and nurses on the set.  The directors were going for an 'authentic' look.  Think of what's not there.  No computers, no imaging technology, no ultrasound.  I think it's fair to say 1968 was a year in modern times - and medicine was very advanced compared to what it had been 40 years earlier.  But there was so much more to be learned. 

I think of social investing in the same way.  Whatever the experts say about efficient markets or the power of quantitative modeling, we simply must admit we don't yet understand financial markets very well.  I am not just trying to score a debating point here.  Our failure to appreciate the magnitude of our ignorance is a real threat to us. 

There was a terrific article (sorry, it costs three bucks) about the Great Depression in The New York Review of Books last year.  Those who think economists march in lockstep should have a look at the debates they have over the Great Depression.  There are still many points of contention.  Ben Bernanke made the role of financial intermediaries in the Depression a particular specialty in his academic career, which is probably really fortunate given his current role.

I occasionally ask the economists I meet if the Great Depression could happen today.  No, they generally say, because we have learned so much.  John Kenneth Galbraith, when asked about this following the 1987 Crash, pointed out that our safety nets are much better-developed.  Milton Friedman and Anna Schwartz pointed out central banking mistakes that almost certainly made a bad situation worse during the Depression- an error Bernanke promised, at a conference honoring Friedman on his 90^th birthday, not to repeat. 

For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

The theme I take from all this is that, back in those days, we just didn't know.  The elites were as confident before the Great Depression as they are today, the speculators were just as arrogant and aggressive.

So what don't we know about the equity market?  Fama and French might argue that we know quite a lot about past patterns of equity returns (an excellent crash course is here).  But as computing power becomes cheaper and backtesting software becomes more sophisticated, isn't it possible that the markets will arbitrage away most of these effects?  Mightn't we move gradually from the world Fama and French observe toward one in which there are no exploitable statistical anomalies?  Some academics think we've already gone there and beyond - with so many people trying to exploit the same effects, herding can occur, making the market less efficient, not more so.

(An aside on market efficiency:  in my adult life the market has traded at 1x book value, in 1980, and 5.5x book value, in 2000.  There's a good chart in this book.  My economist friends tell me we have an efficient market, but I have my doubts.)

But let's say cheap computers and global Internet access do their work, and the market becomes very efficient with respect to quantitative variables.  When that day comes, where do we look next?  Well, everywhere the quants can't reach:  governance, employee relations, sustainability... 

And those happen to be the areas where social investors have been developing their craft these past 20 years.  At our best, I think social investors can help markets identify and appropriately recognize good organizations and good management teams.  Not everything we do maps to those tasks, and there is plenty of work to be done before we can claim to be adept at it.  But that, I think, is the opportunity - social investment techniques may become more important in mainstream investment research.

And this is not really heretical.  Jason Zweig notes in his updated edition of Graham's The Intelligent Investor that Graham wrote a great deal about governance and management quality in the early editions of the book.  As time passed the section got shorter and shorter, because, Zweig speculates, Graham despaired of anyone actually paying attention to it.

Graham well understood that the shareholder is in a vulnerable position.  When you buy a stock you commit your money to an enterprise managed by strangers.  You must ultimately trust those people.  But it is difficult for any layperson to assess whether those managers are honest and competent.  It can even be difficult for well-connected monitors to determine this, as evidenced by recent developments at U.S. financial institutions. 

I would not claim social investors have special insight in these areas today.  Heck, many social investors owned Enron before it went down in flames.  But if you think about where investment practice is going, and where we will have to look to earn returns in the future, I think we are on the right part of the playing field.

Are We Unsound? An Analogy

Due to the emergence of new commitments and the growth of old ones, I am making my final posts to this blog in August/September 2008.  This is the first of two brief essays on the philosophical justification for social investing.

In March the Social Investment Forum released its bi-annual Report on Socially Responsible Investment Trends in the U.S. 

The news appears good for us practitioners – social assets rose 18% over the past two years, compared with just 3% for the market overall.  With one dollar in nine now managed according to some social constraint (mostly tobacco, still) social investing seems to have made a place for itself in the investment world.

And, from Wall Street and most of the famous business schools, a collective yawn.  Now Wall Street has other things on its mind this year.  But even as client interest has increased, my professional and academic colleagues remain mostly disinterested.  And, disturbingly, the most indifferent people are often the most accomplished theorists and practitioners.

I recently realized that I have seen this situation before, in a completely different context .  I hope the comparison will shed light on the intellectual obstacles social investors must yet surmount.

In chess, there is an opening call the Latvian Gambit.  It is a violent response by Black to the most common first move by White, an attempt to turn the game into a desperate and deadly struggle from the outset. 

It’s easy to describe:  On the first move White pushes the pawn in front of the King forward two spaces.  Black does exactly the same thing.  Then White brings out the Knight next to his King, so it attacks the Black pawn.

This is the defining moment – Black can bring out his Queen’s Knight to defend the pawn (the most common choice, leading down well-traveled roads).  Or, Black can counter-attack, bringing out the King’s Knight (this is called Petrov’s Defense, and it is very playable - Kasparov has scored successes with it).  Or, Black can try something sort of crazy.  In the Latvian the player of the Black pieces leaves the King’s pawn undefended, and charges forward two spaces with the pawn in front of his King’s Bishop.  This opens up attacking lines for the Black Queen and dares White to waste time capturing the loose pawn in front of the Black King.  It also opens huge gaps in the Black position, guaranteeing that however exciting the game will be, it will not be a comfortable one for the Black king. 

What happens next is anyone’s guess, but the game will usually be tactically complex, full of cut-and-thrust action, with sudden death a real possibility for both players. 

The Latvian has a loyal following, or cult, if you like.  There are entire leagues of correspondence players who essay the Latvian against one another.  It is certainly not in the mainstream:  critics deride it as a ‘coffee-house opening’.  But when you think about it, that means that in coffee houses all around the world, there are Latvian loyalists – people whose greatest satisfaction of the day is to push that impudent pawn to f5 and smile across the board at the opponent, as if to say – ‘we’re in for it now!’

But there is a problem, and the more serious you are about chess, the more serious it becomes.  The Latvian is entertaining, but it is also almost certainly wrong – a loser against best play.  The English Grandmaster John Watson has denounced it.  The great American chess educator, Jeremy Silman, says simply:  it’s bad.  The only grandmaster work I have seen on the opening – Tony Kosten’s The Latvian Gambit Lives! - seems to acknowledge in places that if White plays a certain way, well, Black will probably lose.  Yes, you can try it against your neighbor, or at your chess club, or even against pretty fair local competition - even Silman says it offers "good practical chances against an unprepared opponent."  But it simply is not seen at the highest-levels of play. 

Is this where we are with social investing?  It is popular, yes, and apparently growing more popular each year.  There is no shortage of people who pay lip service to it.  But most of the strongest academics and practitioners still ignore it.  Some theoreticians are sympathetic, especially on the behavioral side.  But most of those with a strong quantitative bent simply cannot see how social investors can avoid incurring uncompensated risk.  Financial economists (people like Chris Geczy or Brad Barber, for example) will tell you that constraints matter, and that social investment portfolios may be too constrained to achieve optimal results.  So, no matter how sympathetic they might personally be, they are going to have a very tough time believing social investors can earn consistently strong returns relative to the market.

For the most part, with the single exception of the late John Templeton, the best practitioners are also reluctant to go along.  Soros and Buffett have strong social consciences, but no apparent interest in social investing.  The strong practitioners I know say:  We’re playing a competitive game here.  It’s a zero sum game, and you only get paid if you win.  So if you are playing to win – ‘chasing alpha’ as the expression goes - you had better focus on the things that matter for returns.

You might point out to them that some of the things social investors care about do seem to matter for returns.  You could show a few studies (Gunster, Barber, Edmans) that find positive performance effects.  But you’ll just get a wave of the hand.  Maybe, and maybe not, the practitioner says.  You might be bringing me alpha.  But you’re definitely reducing my options, and you’re definitely increasing my tracking error.  In their world, and on their time horizon (usually less than a year), ESG doesn’t matter enough to change their behavior.

So, does that define the role of social investing?  Social investors, if this analogy holds, are the club players of the investment world, trying hard and expending a lot of energy, and perhaps deriving some psychic benefits, but ultimately having no impact on the highest level of play.

I have long been an advocate of social investing because I believe values matter, and if values matter anywhere, they must be exceptionally important in business, where welath is created and most of us spend the majority of our waking lives. 

But this analogy bothers me.  The shoe fits better than I would like.  Perhaps social investors can take comfort in the endorsement of a John Templeton or the sustained interest of a leading investment theorist like Meir Statman.  But for each of these thoughtful people who are sympathetic to social investing, there are ten others who still think it is a dumb little sideshow.

Book Recommendation

I've just finished Dan Ariely's Predictably Irrational, and recommend it to anyone who wants to learn more about behavioral economics.  Ariely is a leader in challenging conventional economic wisdom, and provides empirical evidence of many situations where conventional economic analysis doesn't work well.

I was going to write in this post about the similarities and dissimilarities between this book and Freakonomics, which we've discussed here in the past.  But, procrastination pays once again - Ariely yesterday wrote a note on this himself (read it here). 

The books are similar in many ways, but taken together they frame a multi-disciplinary debate about how far economic analysis takes us.  Behavioral economists are challenging some fundamental assumptions economists like to make about human behavior.  It seems to me they are winning some and losing some, depending on the situation being analyzed - reading both of these books will give you a good sense of whose model might be better in a given situation.

A nice summary of the rise of behavioral finance can be found at Robert Shiller's website.

Michael Porter and Gerstenfeld's Law of Trying

And the 2006 McKinsey Award goes to...Michael Porter for his outstanding article on the role of corporate social responsibility in corporate strategy.  Socialfunds has the story.

Most management articles on corporate social responsibility can be safely ignored.  CSR tends to bring out the worst vices of some management consultants - their reliance on platitudes, sloppiness around definitional issues, and especially their reluctance to quantify.

But Porter's piece strikes me as worthwhile.  On its own merits, it makes good points about which of the myriad social and environmental issues a firm should be most concerned with (those it understands well and has a stake in).  And Porter points out that old-school stakeholder theory (take care of customers, employees, and shareholders and your job is done) doesn't fly anymore.

I suppose I'm also happy to see a prominent management consultant and academic say "when a well-run business applies its vast resources, expertise, and management talent to problems that it understands and in which it has a stake, it can have a greater impact on social good than any other institution or philanthropic organization." 

This is a constructive rejoinder to the CEOs who say "it's not my job".  As Steven Lydenberg has pointed out, the great corporate success of the past 20 years comes with greater corporate obligations.  Porter argues effectively, I think, that corporations are well-equipped to meet them. 

What's missing now, is trying.  Most companies still act as corporate social responsibility is too hard or too expensive.  They are convenient things to say, but come on.  In his classic text on forecasting (available online here) J. Scott Armstrong of the Wharton School invokes Gerstenfeld's law of trying.

It was discovered one night by my friend, Art Gerstenfeld, upon returning home from work.  Gerstenfeld's son met him at the door, and the following exchange took place between the two:

"Daddy, fix my bike for me."

"I don't know anything about bikes."

"Daddy, please fix my bike."

"I don't know how to fix your bike!"

"Daddy, please fix my bike!"

"I don't know how to fix your bike!"

PAUSE

"But, Daddy, you can try, can't you?"

ANOTHER PAUSE

"Yes, I suppose that I can try."

And then he fixed the bike. 

With Porter on board, the time is right to spread the word on Gerstenfeld.

The Economics of Happiness

If you don't like The Economist, wait a week. After the ill-tempered comments of the last post, the latest issue offers this excellent article on happiness and economics.  This is a great piece, offering plenty of historical context, going back to Carlyle and Hume, and giving critical attention to many different points of view.  I was especially happy to see acknowledgement of the contributions of Kahneman, who introduced the radical concept of asking people if they were happy.  And I had not been familiar with the work of Layard (if his new book seems a bit daunting, this article looks like an easier way to get started).

On a somewhat related note, I have been meaning to point out a series of good postings by Macroblog on economists and their critics (here, here, and here).  It is worth looking at these to get a sense of how it feels from the economists' side of of things.

A Notable Abdication

The King of Bhutan, the BBC reports, has abdicated as part of the process of transitioning the country to a parliamentary democracy.  I believe his contribution to the debate about social capital - his concept of Gross National Happiness - deserves far more attention than it has received (Time magazine article is here).

In the U.S. and Europe GDP reports and national income accounts are watched almost obsessively, with significant deviations from trend provoking almost instantaneous policy responses.  The same is not always true for important indicators of happiness and well-being, however.

Bhutan's experiments with the implementation of this concept are widely regarded as successful, but I hasten to add that this success came in a society with one religion (Buddhism) and a leadership with absolute power (although this is now changing). 

A set of discussion papers from a think tank in Bhutan is here.  It is nice, but it is not nearly enough.  Scholars in the social sciences need to do more, collaborating across traditional disciplinary boundaries, to develop a richer understanding of the strengths and weaknesses of this concept.

It won't be easy.  In a recent issue The Economist questioned the value of 'fair trade' and  characterized the challenges of organic food production as a political problem.  The Economist argument wasn't very good economics in the first place (externalities, anyone?), but never mind that.  If they're on form, the political scientists will bat the ball back, saying that the political forces in play are heavily mediated by economic questions, and therefore not their problem either. 

I have no problem with The Economist generally (they once inaccurately called me an economist, doing my career a world of good).  But there's no place for this kind of cop-out anymore.  Bhutan has made a brave start - its up to the rest of us to carry it further.

Jeff MacDonagh on Sin Stocks

Jeff MacDonagh of Domini offers the following response to my note on sin stocks:

"Our take is that they [alcohol, tobacco, and gambling] are all addictive and harmful.  We seek to invest in companies that do not produce addictive and harmful products, as they necessarily harm the customer.  The more that is produced and consumed, the worse off society is.

"You note correctly that alcohol is only potentially harmful, and in fact, may be beneficial in small amounts.  Our concern, in part, reflects how we see publicly traded companies operating – maximizing efficiency, innovation, and product distribution.  Public companies, in general (but not always), act more aggressively in these three ways than private companies, sole proprietorships, etc.  Our screen is not about a boutique vineyard or microbrewery, it is about Budweiser and other publicly traded (large) producers.

"Gambling and tobacco are much easier one to understand – you always lose when consuming this product on a regular, or even fairly occasional, basis. "I think this is an overdue conversation in our world.  I would be happy if the term 'sin stock' was relegated to a historical comment on Wesley’s sermon.  In fact, if you read into 'The Use of Money' – one can interpret 'sin stock' to mean investing in things that are counterproductive, a much more capitalist interpretation than the 'sin stock' term suggests."

Sin Stocks, version 2.0

There is a small contradiction in widely-used social screens that is starting to be noticed. 

Most SRI mutual funds in the U.S. automatically exclude the 'sin stocks'.  Sin stocks are usually defined as alcohol, tobacco, and gambling, although pornography and firearms are sometimes put into this category as well.  The sin screen is appealing because it is consistent with the teaching of many religions, it is easy to implement, and the excluded sectors are small enough as a percentage of the overall market that performance impact is not likely to be severe even if these stocks perform well (which they historically have).

But there are some odd things about this view of sin stocks.  First of all, lumping alcohol, tobacco, and gambling together implies some kind of moral equivalency that really isn't there.  It's not clear that alcohol and gambling, in moderation, are harmful to most people, while tobacco clearly is.  The CDC classifies tobacco as the "leading preventable cause of death" in the U.S.  Alcohol and gambling have their downsides, but they aren't in the same league.

And social investment practitioners do not always practice what they preach.  I've been to many social investment conferences.  Drinks are often served, and consumed enthusiastically.

So it must have been difficult last year for the folks at Pax World to drop Starbucks, an otherwise exemplary social performer (I have it as one of the top 8 U.S. companies), because of a relatively small liqueur deal.  Now Pax is asking shareholders to approve a less restrictive policy (thanks to Lorne Abramson for the heads-up on this).

Pax's proposal strikes me as sensible, although not all religious investors will accept it.  This seems to be a case where the perfect can be the enemy of the good.  Why delete Starbucks for minor involvement in a product that is unlikely to be abused ("hurt anyone in his substance" as John Wesley would say)?  I think many clients would be open to owning shares in a wine company run on sustainabity principles (think of Fetzer when Paul Dolan was at the helm), but this option is foreclosed by the zero tolerance policy.

There are risks to opening the door a little bit, though.  Harley-Davidson got into a similar situation a few years ago, when it licensed its name to Lorillard for a cigarette product.  It went badly, litigation ensued.  As great a company as Harley-Davidson is, I would not have considered including it in an SRI portfolio while this was going on, even though the product was economically insignificant.  (With the situation well in the past, HDI is now on both the Domini and Calvert social indexes.)

I would correct one bit of speculation you see in the news stories - I'm certain this has nothing to do with performance.  Pax World's Balanced Fund is well-managed with a superb long-term track record and four stars from Morningstar.  They don't have to lower the bar to pump up their results.

Economic Determinism vs. Biological Determinism

I've argued before that the underlying intellectual tension in social investing is the rejection by social investors of the idea that people are, or should be, primarily motivated by economic factors (as discussed in last year's Christmas post and Jim Hoopes' reply).

Frans de Waal has written a new book, Primates and Philosophers:  How Morality Evolved.  It is based on a series of lectures he gave at Princeton, and Princeton University Press lets you read chapter 1 free, here.  In a nutshell, de Waal believes morality is a result of human evolution, and is to some degree hard-wired in us. 

This challenges economic determinism with a kind of biological determinism.  On one level I'm happy to see it - economic analysis of human behavior can be frustratingly superficial, so it is nice to see someone push back and argue persuasively that something else - anything else - matters.

But careful what you wish for - if you accept de Waal's account, a host of new questions arise.  If human ethics and morality evolved, what does that say about the philosophy of ethics, which is supposed to be derived from reason - or religion?  I suspect Mr. de Waal will find his share of detractors.

Well, no one said it was going to be simple.  Primates and Philosophers offers good new reasons to pay attention to questions of ethics and morality.  Extra credit for getting a blurb from the estimable Robert Sapolsky:

"Frans de Waal has achieved that state of grace for a scientist--doing research that is both rigorous and wildly creative, and in the process has redefined how we think about the most interesting realms of behavior among nonhuman primates--cooperation, reconciliation, a sense of fairness, and even the rudiments of morality...This is superb and greatly challenging thinking."

'The Use of Money' Online

The definitive history of social investing has not yet been written, but Chapter 1 will have to include a section on John Wesley's sermon, The Use of Money.  Wesley was one of the founders of Methodism, and was noted for his systematic thinking and clear self expression.  He was one of the best-selling authors in England in his day, so he had plenty of opportunity to reflect on the moral aspects of wealth.

First of all, he says, there's nothing wrong with money itself.  "For, let the world be as corrupt as it will, is gold or silver to blame? 'The love of money,' we know, 'is the root of all evil;' but not the thing itself. The fault does not lie in the money, but in them that use it."

His advice is to "get all you can" and "save all you can," but not at the cost of your body or soul.  Don't take a job that could ruin your health.  Don't overcharge your neighbor, or try to run him out of business with predatory pricing.  Don't engage in businesses that hurt other people, either physically (distilling) or spiritually (immoral entertainments).

And then, "give all you can." 

"But let not any man imagine that he has done anything, barely by going thus far, by 'gaining and saving all he can,' if he were to stop here. All this is nothing, if a man go not forward, if he does not point all this at a farther end. Nor, indeed, can a man properly be said to save anything, if he only lays it up. You may as well throw your money into the sea, as bury it in the earth. And you may as well bury it in the earth, as in your chest, or in the Bank of England. Not to use, is effectually to throw it away."