SRI Notes

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.

Nice Update on the Performance Debate

No author is credited, but there is a concise and balanced review of recent evidence on SRI performance at the website of Phillips, Hager & North, a Canadian investment firm. In addition to the more widely-known evidence, they cite several Canadian studies I hadn't seen, and reach the usual conclusion that no cost to SRI has been observed.

But the anonymous writer finishes with an important point:

"The question of whether or not SRI reduces investment returns will never be laid to rest. One reason is that this is a difficult empirical question and there will always be legitimate disputes over the quality of the data and the most appropriate methodology to use. Perhaps more importantly, this question will never be answered to everyone's satisfaction because many of the people engaged in this debate carry with them strong ideological baggage. Opponents of SRI are so against the notion of anything other than financial factors affecting the value of a security that, in their view, 'hell will freeze over' before they accept that this is not the case. Likewise, some proponents of SRI are so steeped in their own moral superiority that they cannot fathom the possibility that the integration of social and environmental factors does not have a beneficial effect on investment returns. The challenge for the rest of us is to ignore the rhetorical noise emanating from these extreme views and focus on the facts."

There's one other reason why we'll never have a final answer - the social screens themselves change over time.  When the Domini Index was first developed in the late 1980s, South Africa was a key issue.  In the early 1990s the emphasis shifted to the environment.  Later on international labor standards moved to the forefront, and then corporate governance.  So even if the ideological noise could be set entirely aside, we still would never have a final answer.

This is a familiar problem in finance.  A physicist friend once told me that physicists tend to have a hard time on Wall Street.  "Gravity has worked the same way for millions of years," he explained, but the markets are not so cooperative.