The jury’s in: SRI does not mean lower returns.
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Socially responsible investing (SRI)—that is, basing investment decisions on environmental, social and governance (ESG) factors—is not new. In fact, it’s been around for more than a century. And throughout this time, people have debated whether SRI leads to lower returns.
Why do people think differently about SRI?
Opponents of SRI argue that it must result in lower returns, simply because there are fewer companies to invest in. This position reflects ‘Modern Portfolio Theory’, which states that portfolios chosen from 2,000 companies will be more efficient than portfolios chosen from 1,000 companies.
Proponents of SRI follow the ‘Stakeholder Theory’. This states that companies using unsustainable activities will underperform competitors, and that, while SRI has fewer choices, those choices are more attractive. (There’s also a third view: that there is no difference between long-term returns of SRI and other funds with comparable mandates. This is called the ‘Best-of-Sector ESG’ approach, which compares companies that follow ESG practices with other companies in their peer group.)
A 2019 study by a major Canadian financial institution* concluded that SRI does not result in lower returns.
The study assessed the results of a comparison of SRI returns and the returns of four other groups: index comparison, mutual fund comparison, hypothetical portfolios, and company performance.
Index comparison requires comparing the performance of SRI indices with traditional indices. (An index is a number of securities constructed to represent a particular market or asset class. An example is the S&P/TSX Composite Index—250 companies representing the Canadian stock market.)
Comparing the results of the two types of indices is complex, because of differences in how the index is constructed, ESG evaluation processes, style, industry, and size biases or growth biases. Recent studies focused on identifying and addressing these biases, and results have shown that there was little difference between the performance of SRI indices and their traditional counterparts.
The study cites numerous and detailed U.S. examples, but in Canada, the Responsible Investment Association of Canada compared the returns of the Jantzi Social Index** with the S&P/TSX Composite Index and the S&P/TSX 60 Index from inception to May 2018. It also compared the returns of the MSCI World SRI Index with the MSCI World Index from 2007 to 2018. Both comparisons found the SRI indices outperformed their traditional counterparts.
CANADIAN INDEX COMPARISONS
Jantzi Social vs S&P/TSX 60
While research comparing equity SRI and non-SRI indices is plentiful, and demonstrates that equity SRI indices do not underperform traditional indices, there are fewer examples of research on other asset classes. However, in 2016, Barclays published a report comparing their Socially Responsible Corporate Bond Index and their Sustainability Index with the Bloomberg Barclays US Corporate IG Index. The findings showed that a positive ESG screen applied to an investment-grade credit portfolio can actually enhance returns.
Mutual fund comparisons compared the performance of SRI mutual funds with traditional mutual funds and/or traditional market indices.
Comparing this research is also challenging for several reasons, including the fact that studies have been limited to specific geographic regions and there is great variety amongst funds with the SRI label. In addition, in an effort to attract a growing market of millennial and female investors, some funds have labelled themselves ‘SRI’ without necessarily following SRI principles.
The report cites 36 studies in different countries. A 2012 study by Liang compared 28 Canadian ethical funds to the TSX Index and found that ethical funds tended to underperform the market by 4%; while Canadian fixed income ethical funds outperformed the market by 5%.
The general finding was that when SRI investors excluded companies (called ‘negative screening’), it detracted from performance, and when investors focus on companies with high rates of ESG indicators (or ‘positive screening’), performance was improved. When both types of screening are used, the negative and positive impacts offset each other, so there’s ultimately no impact on performance. While more research would be required to reach definitive conclusions, evidence to suggest that SRI funds systematically underperform traditional mutual funds is limited.
Hypothetical portfolios analysis works by creating hypothetical portfolios of companies that follow ESG factors with non-screened portfolios.
Studies have used a variety of screens, including best-in-class ESG score screens, screening based on international norms, and traditional sin stock screens (‘sin’ refers to a company that is involved in business activities deemed to be unethical, such as alcohol, tobacco, gambling, or weapons).
One 2016 study looked at the impact of screening on return, risk, and diversification. It found that:
- in 3 out of 4 portfolios, the increase in risk compared to the non-screened portfolio was outweighed by the increase in alpha (the excess return of an investment relative to the return of a benchmark index),
- 3 out of 4 screened portfolios outperformed their non-screened counterparts on a risk-adjusted basis, and
- SRI screening does not lead to loss of diversification.
Corporate social performance compares the financial performance of companies that score highly on measures of good corporate social responsibility (CSR), with those that do not.
CSR is purported to deliver benefits ranging from an ability to attract and retain better and more productive employees, to good relations with stakeholders like government and communities. Some opponents claim that, at best, CSR is neutral (i.e. there are no financial advantages). Others claim that it has negative results, because companies practising CSR are distracted from their main job: maximizing profits. However, a variety of research shows the following:
- There is a positive relationship between stock performance and strong governance practices, strong environmental performance, and high employee satisfaction.
- When sustainability scores are aggregated, they demonstrate positive impact on performance.
- Companies with high ESG ratings outperform the market in the medium (3-5 years) and long term (5-10 years); and also have a lower cost of debt and equity.
- Strong ESG practices improve operational performance.
- CSR considerations in stock market portfolios do not result in financial weakness.
- Companies that prioritize sustainability manage environmental, financial and reputational risks better, which increases the likelihood of reduced volatility of cash flows.
Strong conclusions in studies of corporate social performance are difficult to draw because of methodological weaknesses in the studies.
In conclusion, socially responsible investing does not result in lower investment returns.
While staunch opponents of SRI may refuse to acknowledge that anything other than financial factors can affect the value of a security, and proponents cannot believe that incorporating their beliefs and values would have a detrimental effect on returns, the results are definitely in.
Although some of the research in the study faces methodological challenges, investors interested in SRI can rest assured that returns will be, if not superior, at least similar to traditional investment options.
Questions? Ask your Educators Financial Advisor.
At Educators Financial Group, we know that being socially responsible matters to education members. Our Financial Advisors can answer your questions about SRI and the options you have available at Educators.
Call us today at 1.800.263.9541 or get in touch online.
Sources:
*https://www.rbcgam.com/documents/en/articles/does-socially-responsible-investing-hurt-investment-returns.pdf
**Jantzi Social Index: A socially screened, market capitalization-weighted, common stock index modeled on the S&P/TSX 60 consisting of 50 Canadian companies that pass broad set of ESG criteria.
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