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Does Ethical Based Investing Impact Returns?

Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that you’re seeking not only profitable investments, but also investments that meet your personal standards. Some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages or weapons, or firms that rely on animal testing as part of their research and development efforts. Other investors may be concerned about social, environmental, governance, labor or religious issues.

It is important to note, however, that SRI encompasses many personal beliefs and doesn’t reflect just one set of values. Therefore, it’s no surprise that each socially responsible fund relies on its own carefully developed “screening” system.

Analyzing the Numbers

According to the Social Investment Forum (SIF), U.S. SRI assets under management registered an increase from $639 billion in 1995 to $3.7 trillion in 2012, and an increase in their relative market share from 9 percent to 11 percent over the same period. Given their growth, an important question is whether “ethics-based” investing can impact returns. Sadok El Ghoul and Aymen Karoui — the authors of the

December 2015 study, How Ethical Compliance Affects Portfolio Performance and Flows: Evidence from Mutual Funds — sought the answer to that question.

The authors applied value-weighted scores using firm-level holdings to assess the level of corporate social responsibility (CSR) of a fund. This allowed them to compare fund performance based on the CSR criterion. To rate individual companies, they employed a KLD database. KLD Research & Analytics is a leading authority on social research for institutional investors, offering research, benchmarks, compliance and consulting services analogous to those provided by financial research service firms.

The authors considered two competing hypotheses. On the one hand, investing in firms that comply with social responsibility practices is likely to reduce the set of investment opportunities available and increase their monitoring costs. Ethical compliance would then negatively impact financial performance. On the other hand, fund managers that target socially responsible firms might in fact target firms with solid financial fundamentals, which in turn would translate into higher performance. In other words, the multiple screening steps taken by fund managers may eliminate poorly managed companies with underperforming stocks. In this case, investing in socially responsible stocks would be a value-generating strategy.

Their study covered the period from 2003 through 2011 and 2,168 U.S. equity mutual funds. To measure risk-adjusted returns, the authors used the four factors of market beta, size, value and momentum. The following is a summary of their findings:

  • High-CSR funds attract larger flows.
  • High-CSR funds tend to hold fewer stocks; they are less diversified.
  • There is strong evidence that an increase in the level of CSR comes at the expense of a reduction in performance. Said another way, the CSR level of the portfolio is negatively related to its risk-adjusted performance. This result stands controlled for common fund characteristics such as volatility, flows, the size of the assets under management, the number of stocks, the expense ratio and turnover.
  • The alpha, or the annualized risk-adjusted return (net of fees), of low-CSR funds was -0.8 percent, while the alpha of high-CSR funds was -1.5 percent. The difference, 0.7 percent, was highly statistically significant (t-stat of 5.8). The difference could not be explained by the expense ratios because they were virtually identical (1.24 percent for low-CSR funds and 1.21 percent for high-CSR funds).
  • The CSR level negatively predicts the next year’s fund performance.
  • There is no evidence of persistence in performance beyond a horizon of one year. Funds with a highCSR score exhibit weaker persistence or higher reversal in their performance.
  • Evidence in the literature on mutual funds has shown that investor flows respond positively and significantly to past performance. However, this relationship weakens as the level of CSR increases. Investors in funds with higher ethical standards become less responsive to past performance and derive their utility from non-financial attributes. As the level of ethical compliance increases, it becomes more difficult for investors to find similar investment alternatives and therefore they may be more reluctant to switch to other funds, even when these funds register poor performance.

The authors noted that their findings were consistent with those of a study appearing in the November 2015 issue of the Journal of Banking and Finance, Do Social Factors Influence Investment Behavior and Performance? Evidence from Mutual Fund Holdings. Funds that are more invested in “sin” stocks display higher risk-adjusted performance.

The findings mentioned above are also consistent with those from Harrison Hong and Marcin Kacperczyk, authors of the study, The Price of Sin: The Effects of Social Norms on Markets, which appeared in the July 2009 issue of the Journal of Financial Economics.

They found that for the period from 1965 through 2006, a portfolio long sin stocks and short their comparables had a return of 0.29 percent per month after adjusting for a four-factor model comprised of the three Fama-French factors (beta, size and value) and the momentum factor. The statistics were economically significant. In addition, as out-of-sample support, they found that sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5 percent a year.

The Bottom Line

The conclusion that we can draw from these studies is that social norms have important consequences for the cost of capital of “sin” companies. They also have consequences for SRI investors, who pay a price in the form of lower expected returns and less effective diversification.

While many investors will vote “conscience” over “pocketbook,” there is an alternative to socially responsible investing at least worth considering: avoid socially responsible funds and donate the higher expected returns to the charities that you are most passionate about. In that way you can directly impact the causes you care deeply about and get a tax deduction at the same time.

By, Larry Swedroe

Director of Research for the BAM ALLIANCE

This commentary originally appeared February 9 on MutualFunds.com.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of Hoffman & Associates. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

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The Secret Wall Street Doesn’t Want You to Know

I am not endorsing any political views, but I did note an observation made by Bernie Sanders in the recent Democratic presidential primary debate. He stated that Wall Street’s “business model is greed and fraud.” There’s a lot of data supporting that view.

A history of unethical conduct

The Securities and Exchange Commission (SEC) compiled a list of enforcement actions that led to or arose from the financial crisis. Here’s a small sampling:

Citigroup – The SEC charged Citigroup’s principal U.S. broker-dealer subsidiary with misleading investors about a $1 billion collateralized debt obligation (CDO) tied to the housing market in which Citigroup bet against investors as the housing market showed signs of distress. The court approved a settlement of $285 million, which will be returned to harmed investors.

Deutsche Bank AG – The SEC charged the firm with filing misstated financial reports during the financial crisis. Deutsche Bank agreed to pay a $55 million penalty.

Goldman Sachs – The SEC charged the firm with defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter. Goldman agreed to pay a record penalty in a $550 million settlement and reform its business practices.

J.P. Morgan Securities – The SEC charged the firm with misleading investors in a complex mortgage securities transaction just as the housing market was starting to plummet. J.P. Morgan agreed to pay $153.6 million in a settlement that enables harmed investors to receive all of their money back.

Merrill Lynch – The SEC charged the firm with making faulty disclosures about collateral selection for two CDOs that it structured and marketed to investors, and maintaining inaccurate books and records for a third CDO. Merrill Lynch agreed to pay $131.8 million to settle the charges.

Even though penalties ordered or agreed to as a result of misconduct surrounding the financial crisis exceed $1.9 billion, the fines paid by these firms and others amounted to little more than a slap on the wrist.Many believe it’s back to “business as usual” for them.

Perpetuating a belief in an expertise that doesn’t exist

That “business” means persuading you to give them your money to “manage.” This is no mean feat. The data is overwhelming that the securities industry does not have the expertise to “beat the market” reliably and consistently. A recent Standard & Poor’s Indices Versus Active (SPIVA) scorecard found that over the one-, five- and 10-year periods ended Dec. 31, 2014, more than 80 percent of large-cap actively managed funds failed to deliver incremental returns over the benchmark.

Think about that information. The S&P 500 index consists of the 500 largest and best-known publicly traded companies in the United States. To “beat the benchmark,” all active managers have to do is overweight the winners and underweight the losers. As my colleague, Larry Swedroe, recently noted, 2014 gave them plenty of opportunity to do so. There were vast differences in the returns of the 10 best-performing and the 10 worst-performing stocks in the index that year.

If active managers had skill, surely more than a small minority would have been able to identify the “winners.”

Better alternatives

As I previously discussed, investors familiar with this hustle have a far better alternative. They can simply refuse to entrust their money to those with no demonstrated expertise. Instead, they can choose to become evidence-based investors and capture global returns using low management fee index funds.

This prospect is Wall Street’s worst nightmare. It has marshaled its vast resources and is fighting back witharticles extolling the purported benefits of active management.

Meritless advice

Jim Cramer leads Wall Street’s charge. Here’s the “advice” he gave in a September 2015 article to those just starting out on their investment journey. It’s so irresponsible that I want to quote it.

Cramer is credited as saying that he believes a diversified portfolio of five to 10 individual stocks is the best way to maintain a portfolio.

The article then goes on to quote him directly: “Now, before you start picking stocks, you need to forget everything you’ve ever heard about that classic piece of so-called investing wisdom, buy and hold. We don’t buy and hold here on ‘Mad Money’ — it’s a great way to lose your shirt.”

As usual, Cramer referenced no data to support these views. In reality, the latest research indicates that, for investors in U.S. equities, to be confident of reducing 90 percent of diversifiable risk 90 percent of the time, the number of stocks required is, on average, about 55. In times of distress, it can increase to more than 110 stocks.

Investors can easily reduce risk through appropriate diversification by purchasing low management fee index funds.

Cramer’s observation that a “buy and hold” strategy is “a great way to lose your shirt” is also belied by the evidence. For the period from Dec. 31, 1993 through Dec. 31, 2013, the average investor had an annualized return of about 2.2 percent. Investors who “bought and held” an index fund tracking the S&P 500 earned 8.5 percent, less the low management fees charged by the fund.

Ironically, the best way to “lose your shirt” might be to follow Cramer’s stock picking advice. In a well-reported debacle, on April 6, 2015, Cramer gave his hapless viewers a list of 49 stocks to “buy right now.” Six months later, only 28 percent of them closed higher than their April trading price. In just six months, investors who followed Cramer’s advice lost 7.09 percent of their money.

Once you recognize that Cramer and many others in the financial media are just shills for an industry that wants you to chase returns, buy and sell stocks and bounce in and out of the market, you will have made a giant step toward investing in an intelligent, responsible — and evidence-based — manner.

This commentary originally appeared December 8 on HuffingtonPost.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.


Dan Solin is director of investor advocacy for the BAM ALLIANCE.

Dan is a New York Times bestselling author. His latest book, The Smartest Sales Book You’ll Ever Read, was just released.

The author of several books on investing, his Smartest series includes:

• The Smartest Sales Book You’ll Ever Read
• The Smartest Investment Book You’ll Ever Read
• The Smartest 401(k) Book You’ll Ever Read
• The Smartest Retirement Book You’ll Ever Read
• The Smartest Portfolio You’ll Ever Own
• The Smartest Money Book You’ll Ever Read

In addition, he writes financial blogs for The Huffington Post, Daily Finance, Advisor Perspectives and USNews.com.

Dan is a graduate of Johns Hopkins University and the University of Pennsylvania Law School.