Larry Swedroe checks the research on socially responsible vs. "vice" investing.
Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that investors are seeking not only profitable investments, but investments that meet their personal standards.
For instance, some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages or weapons, or rely on animal testing as part of their research and development efforts. Other investors may also be concerned about environmental, social, governance (ESG) or religious issues. It is important to note that SRI and the broader category of ESG encompass many personal beliefs and don’t reflect just one set of values.
SRI has gained a lot of traction in portfolio management in recent years. In 2016, socially responsible funds managed approximately $9 trillion in assets from an overall investment pool of $40 trillion in the United States, according to data from US SIF.
While SRI and ESG investing continue to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the share prices will be depressed. They will have a higher cost of capital because they will trade at a lower P/E ratio, thus providing investors with higher returns (which some investors may view as compensation for the emotional “cost” of exposure to offensive companies).
The Other Side Of The Coin
Thus, an investment strategy that focuses on the violation of social norms has developed in the form of “vice investing” or “sin investing.” This strategy creates a portfolio of firms from industries that are typically screened out by SRI funds, pension funds and investment managers. Vice investors focus primarily on the “sin triumvirate”: tobacco, alcohol and gaming (gambling) stocks. The historical evidence on the performance of these stocks supports the theory.
Greg Richey provides the latest contribution to the literature on the “price of sin” with his January 2017 paper, “Fewer Reasons to Sin: A Five-Factor Investigation of Vice Stocks.” His study covered the period October 1996 to October 2016.
Richey employed the single-factor CAPM model (market beta), the Fama-French three-factor model (adding size and value), the Carhart four-factor model (adding momentum) and the new Fama-French five-factor model (market beta, size, value, profitability and investment) to investigate whether a portfolio of vice stocks outperforms the S&P 500, a benchmark to approximate the market portfolio, on a risk-adjusted basis. His dataset included 61 corporations from vice-related industries. Following is a summary of his findings:
Richey’s findings are consistent with other studies on sin stocks.
Further Evidence
Harrison Hong and Marcin Kacperczyk, authors of the study “The Price of Sin: The Effects of Social Norms on Markets,” published in the July 2009 issue of the Journal of Financial Economics, found that for the period 1965 through 2006, a U.S. portfolio long sin stocks and short their comparables had a return of 0.29% per month after adjusting for the four-factor model.
As out-of-sample support, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a year. They concluded that the abnormal risk-adjusted returns of vice stocks are due to neglect by institutional investors, who lean on the side of SRI.
As further evidence that avoiding sin stocks comes at a price, Elroy Dimson, Paul Marsh and Mike Staunton found that, when using their own industry indices that covered the 115-year period of 1900 through 2014, tobacco companies beat the overall equity market by an annualized 4.5% in the U.S. and by 2.6% in the U.K. (over the slightly shorter 85-year period from 1920 through 2014). Their study was published in the 2015 Credit Suisse Global Investment Handbook.
They also examined the impact of screening out countries based on their degree of corruption. Countries were evaluated using the Worldwide Governance Indicators from a 2010 World Bank policy research working paper by Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues.” The indicators comprise annual scores on six broad dimensions of governance.
Dimson, Marsh and Staunton found 14 countries that posted a poor score, 12 that were acceptable, 12 that were good and 11 with excellent scores. Post-2000 returns for the last three groups were between 5.3% and 7.7%. In contrast, the markets with poor control of corruption had an average return of 11.0%.
Interestingly, realized returns were higher for equity investments in jurisdictions that were more likely to be characterized by corrupt behaviors. As the authors note, the time period is short and the result might just be a lucky outcome.
On the other hand, it’s also logical to consider that investors will price for corruption risk and demand a premium for taking it. But it may also be a result of the same exclusionary factors found with sin stocks (investors boycott countries with high corruption scores, driving prices down, raising expected returns).
Socially Responsible Factors
Meir Statman and Denys Glushkov contributed to the literature on SRI with their study, “Classifying and Measuring the Performance of Socially Responsible Mutual Funds,” which was published in the Winter 2016 issue of The Journal of Portfolio Management. Their contribution was to add two social responsibility factors to the commonly used four-factor model (beta, size, value and momentum).
The first social responsibility factor they propose is the top-minus-bottom factor (TMB), consisting of employee and customer relations, environmental protection, diversity and products. The second factor is the accepted-minus-shunned factor (AMS), consisting of the difference between the returns of stocks of companies commonly accepted by socially responsible investors and the returns of stocks of companies they commonly shun. Shunned stocks included those of companies in the alcohol, tobacco, gambling, firearms, military and nuclear industries.
Statman and Glushkov built their social responsibility factors with data from the MSCI ESG KLD STATS database and note: “The two social responsibility factor betas capture well the social responsibility features of indices and mutual funds. For example, TMB and AMS betas are higher in the socially responsible KLD 400 Index than in the conventional S&P 500 Index.”
The authors’ study covered the period January 1992 (when data first becomes available) through June 2012. To construct their two social responsibility factors, they calculated each company’s TMB-related score (total strengths minus total concerns) at the end of each year based on their set of five social responsibility criteria (employee relations, community relations, environmental protection, diversity and products) and its AMS-related score, based on whether it is “shunned” or accepted. They then matched the year-end scores with returns in the subsequent 12 months.
TMB And AMS
The long side of the TMB factor is a value-weighted portfolio of stocks from firms that rank in the top third of companies sorted by industry-adjusted net scores in at least two of their five social responsibility criteria and not in the bottom third by any criterion.
The short side of the TMB factor is a value-weighted portfolio of stocks from firms ranked in the bottom third of companies sorted by industry-adjusted net scores in at least two of the five social responsibility criteria and not in the top third by any criterion.
Similarly, the long side of the AMS factor is a value-weighted portfolio of the accepted companies’ stocks, and its short side is a value-weighted portfolio of shunned companies' stocks. The authors constructed the TMB and AMS portfolios as of the end of each year. Following is a summary of their findings:
Statman and Glushkov concluded: “A lack of statistically significant differences between the performances of socially responsible and conventional mutual funds is likely the outcome of socially responsible investors’ preference for stocks of companies with high TMB and high AMS. The first preference adds to their performance, whereas the second detracts from it, such that the sum of the two is small. A proper analysis of socially responsible mutual funds’ performance requires separate accounting for the effects of TMB and AMS on performance.”
Their finding that the AMS factor produces negative alpha is consistent with both the theory I mentioned previously and prior research.
An Anomaly
The finding of positive alpha for the TMB factor, however, is a puzzle for the same reason that the negative alpha for AMS should be expected. If enough SRI investors shun stocks with low TMB scores, the cost of capital of such companies will rise, and so will their expected returns. Hence the apparent anomaly.
A possible explanation is that perhaps the alpha could be explained by exposure to another factor (such as quality or low beta) not included in the four-factor model (beta, size, value and momentum).
Other explanations can be found in the behavioral finance literature. For example, the 2011 study from Alex Edmans, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,” found that stocks of companies with highly satisfied employees earned higher returns than other stocks.
The 2005 study, “The Eco-Efficiency Premium Puzzle,” by Jeroen Derwall, Nadja Guenster, Rob Bauer and Kees Koedijk, found that stocks of companies with good environmental records earned higher returns than other stocks.
And the 2007 study by Alexander Kempf and Peer Osthoff, “The Effect of Socially Responsible Investing on Portfolio Performance,” found that stocks of companies that ranked high overall on community, diversity, employee relations, environment, human rights and products did better than stocks that ranked low on those measures. In each case, higher returns could result from investor myopia—they tend to focus on possible negative short-term costs (such as higher wages) and underestimate long-term benefits.
One final comment: Investors may be aware that there are trade-offs between wants, and some are willing to trade the utilitarian benefit of higher expected returns for the expressive and emotional benefits of avoiding the stocks of shunned companies.
This commentary originally appeared March 3 on ETF.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.
© 2017, The BAM ALLIANCE
Recent research shows UIT managers exhibit poor stock selection skills.
Unit investment trusts (UITs) are SEC-regulated investment vehicles in which a portfolio of securities is selected by a sponsor and deposited into the trust. Although the number of UITs has fallen from approximately 12,000 in 1990 to about 5,000 by the end of 2014, assets held in UITs have grown steadily since the financial crisis, increasing from about $20 billion at the end of 2008 to more than $100 billion by 2015. (These numbers exclude the eight ETFs that are structured as unit investment trusts.)
Unlike mutual funds, equity UITs invest in fixed portfolios of stocks for a predetermined period of time. Generally, equity UITs terminate within two years of their launch date (although some are longer), with many of them terminating at one year. At the end of this specified term, holdings are liquidated and investors receive the proceeds from their investment. A benefit of UITs is that, unlike mutual funds, they don’t have to hold cash to meet redemption needs. The lack of a “cash drag” provides UITs with an advantage. And their lack of turnover keeps total costs down.
Importantly, the fixed portfolio (buy and hold to termination date) of UITs provides a unique sample to specifically measure stock selection skill (isolating it from the other part of active management, market timing).
REIT UITs
Kimberly Luchtenberg, author of the January 2017 paper “REIT Unit Investment Trusts and Fund Manager Skill,” examined the stock selection skills of fund managers using a sample of real estate investment trust (REIT) UITs. As Luchtenberg hypothesizes, a benefit of limiting the study to REIT UITs, instead of the entire UIT universe, is that, because “the REIT population is much smaller than the entire population of stocks, it would be reasonable to suspect that informed managers have the ability to become more skilled at selecting REITs than they are at selecting stocks in general.”
Her study covered the period May 2009 through July 2015 and 37 REIT UITs, each holding 25 REITs using an equal weighting. Because managers must sell assets at the end of the term, and market impact costs can occur, returns nine days from the UIT’s termination date are excluded (of course, investors still must bear those costs, but this is separate from the issue of stock selection skill).
Luchtenberg used the Fama-French three-factor model (beta, size and value) and the Carhart four-factor model (adding momentum), with the data for high minus low (HML), small minus big (SML) and momentum (MOM) coming from Kenneth French's website. Luchtenberg found that REIT UITs deliver negative three-factor and four-factor alphas, though the results were not statistically significant.
We can also observe whether active management is likely to add value for REIT mutual funds. For the 15-year period ending in 2016, the Vanguard REIT Index Fund (VGSLX) posted a Morningstar percentile ranking of 39, meaning it outperformed 61% of the surviving REIT funds. However, Morningstar’s ranking contains survivorship bias. Over that 15-year period, 18 of the 50 REIT funds that existed at the start of the period were no longer in the database—just 32 survived.
If we adjust for survivorship bias by making the assumption that the nonsurvivors had below-benchmark returns, then VGSLX’s ranking changes to the 25th percentile. It outperformed 75% of actively managed REIT funds. In other words, active management is just as much of a loser’s game in REITs as it is elsewhere—it’s a game that, while it’s possible to win, the odds of doing so are so poor, that it’s not prudent to try.
Further Evidence On UITs
George Comer and Javier Rodriguez, authors of the May 2015 paper “Stock Selection Skill, Manager Flexibility, and Performance: Evidence from Unit Investment Trusts,” examined the performance of 1,487 diversified UITs over the period 2004 through 2013. The authors excluded sector UITs, such as the REIT UITs that Luchtenberg studied.
In analyzing the performance of UITs, Comer and Rodriguez compare their returns to four benchmarks. The first is the single-factor (beta) CAPM model. The second is the Carhart four-factor model (beta, size, value and momentum). Because the UITs held an average of about 12% in international equities, the authors used a third model, adding an international index (the MSCI World ex U.S. Index) to the Carhart model. Their fourth model was a trust-specific benchmark, such as a Dow Jones sector index. Following is a summary of their findings:
Comer and Rodriguez concluded their tests suggest that the negative alphas of UITs reflect poor stock-selection skill. This is an interesting finding, one that’s very different from the evidence on actively managed mutual funds. Studies on individual investors have found they also exhibit poor stock selection skills, but this isn’t true for mutual funds.
For example, a study by Russ Wermers, “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses,” which was published in the August 2000 issue of the Journal of Finance, found that, on a risk-adjusted basis, the stocks’ active managers outperformed their benchmark by 0.7% per year. Unfortunately for investors, stock-picking alpha wasn’t close enough to generate alpha after expenses, as total costs, including the cost of “cash drag,” exceeded 2%.
The evidence makes clear that UITs are another in a long list of products that are meant to be sold (because of the high sales charges embedded in them), but never bought. The bottom line is that, whether we’re looking at UITs or actively managed mutual funds, investors are more likely to achieve their goals by limiting their investments to passively managed vehicles.
This commentary originally appeared February 27 on ETF.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.
© 2017, The BAM ALLIANCE
Tim Maurer with his three-step guide to navigating the fiduciary issue.
As an educator in the arena of personal finance, I generally avoid matters of public policy or politics because they tend to devolve into dogma and division, all too often leaving wisdom and understanding behind. But occasionally, an issue arises of such importance that I feel an obligation to advocate on behalf of those who don’t have a voice. The issue of the day revolves around a single word: “fiduciary.”
At stake is a Department of Labor ruling set to take effect this coming April that would require any financial advisor, stock broker or insurance agent directing a client’s retirement account to act in the best interest of that client. In other words, the rule would require such advisors to act as a fiduciary. The incoming Trump administration has hit the pause button on that rule, a move that many feel is merely a precursor to the rule’s demise.
Why? Because a vocal constituency of the new administration has lobbied for it—hard. They stand to lose billions—with a “b”—so they’re protecting their profitable turf with every means necessary, even twisted logic.
The good news is that informed investors need not rely on any legislation to ensure they are receiving a fiduciary level of service. Follow these three steps to receive the level of service you deserve:
1) Ask your advisor if he or she acts as a fiduciary.
It’s not a good sign if you get the deer-in-headlights look followed by “Fid-oo-she-WHAT?” If your advisor gets defensive, telling you that you’re better off with the status quo, that’s also concerning.
2) Ask your advisor if he or she acts ONLY as a fiduciary.
One of the biggest challenges facing investors today is that many advisors with a genuine fiduciary label are actually part-time fiduciaries. This is where it gets tricky, because there are at least three different regulatory requirements in the financial industry.
Those beholden to the Investment Advisers Act of 1940 and regulated by the SEC are fiduciaries already, and they have been for a long time. Those who sell securities—typically known as stock brokers and regulated by FINRA—are held to a lesser “suitability” standard. Those who sell insurance products may be beholden to an even lesser standard—caveat emptor, or “buyer beware.”
But what if your advisor is like many who are licensed sufficiently that they may act as a fiduciary when they choose, but may also take off the advisory hat and sell you something as a broker or agent? Do they tell you when they’ve gone from one to the other?
You want a full-time, one-hat-wearing fiduciary.
3) Determine if your advisor is a TRUE fiduciary.
This may be the hardest part, because it requires you to read between the lines. There are advisors who now realize that it’s simply good business to be a fiduciary. And while there’s nothing wrong with profitable business, you don’t want to work with someone just because they’ve realized fiduciary mousetraps sell better than their rusty predecessors.
Not everyone who is a fiduciary from a legal or regulatory perspective is a fiduciary at heart, and yes, it is also true that there are those who are fiduciaries at their core even though they don’t meet the official definition in their business dealings.
You want a practitioner who’s a fiduciary through-and-through—a fiduciary in spirit and in word.
“The annulment of the government’s fiduciary rule would clearly be a setback for investors trying to prepare for retirement,” says sainted financial industry agitate Jack Bogle. “But the fiduciary principle itself will live on, and even spread.”
Yes, the good news—for both advisors and investors—is that there is a strong and growing community of fiduciaries, supported by the Certified Financial Planner™ Board, the Financial Planning Association (FPA) and the National Association of Personal Financial Advisors (NAPFA).
Advisors can join the movement. And investors can insist on only working with a true, full-time fiduciary.
This commentary originally appeared February 24 on Forbes.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.
© 2017, The BAM ALLIANCE