Alpha or Beta? The Financial Value of Sustainability
Commentary by Julie Fox Gorte, Senior Vice President, Sustainable Investing
Every profession probably has its gotcha question, the $64,000 “what did he know and when did he know it” conversation-stopper. In the world of socially responsible investing, the question comes down to performance: “Can SRI possibly perform as well as mainstream investing?” There is a permutation of this question aimed at companies (“Do responsible corporate citizens sacrifice financial performance?”), which is more or less that same thing.
There are dozens of academic studies addressing these issues, covering different time periods, investment styles, geographies, and using a variety of methods. Most of them come to the conclusion that adding so-called extra-financial criteria (e.g., environmental management, corporate governance, labor relations) does not necessarily hurt the performance of an investment portfolio. A smaller proportion of the academic literature concludes that incorporating some kind of environmental, social and governance (ESG) criteria can actually improve financial performance, while an even smaller – indeed, very small – number of studies conclude that “screening” or “SRI” criteria impairs financial performance.
This is how science—social or otherwise—works. We advance a proposition, based on our understanding of the unifying principles of the universe in question, and then test it against real-world information. Once we have run enough tests, or devised instruments to see the world more clearly, we may arrive at something that most people accept as true. In the case of socially responsible investing, the compass readings seem to have converged on the conclusion that the incorporation of certain “extra financial” (i.e., social) screens or criteria doesn’t hurt performance. In the case of sustainable investing – which we at Pax World view as related to, but distinct from, traditional SRI – a growing body of evidence points to the materiality of ESG criteria, suggesting that incorporating the same into investment analysis and decision making may in fact enhance performance.
The notion that incorporation of certain sustainability measures can actually benefit financial performance was demonstrated in an interesting test done by Innovest and referenced in a recent Watson Wyatt paper.1 Over a three-year period (2002-4), Innovest simulated the effect of incorporation of its environmental ratings on portfolios of large US pension funds by adjusting, on a month-by-month basis, portfolio weightings according to Innovest’s environmental ratings – in other words, overweighting the best environmental performers. Over this time period, these environmentally weighted portfolios outperformed the actual portfolios for every scenario (low, medium, and high tilt) in almost every asset class examined. The results were similar over even longer timeframes as well. Another recent paper also showed that returns were higher for companies that ranked highly on Innovest’s eco-efficiency measures over a period of more than seven years, outperforming both a market proxy and companies with lower rankings.2
Innovest’s work shows that environmental performance does—or at least can—enhance portfolio returns over a substantial timeframe. More recently, Goldman Sachs has also shown that integration of financial analysis with ESG metrics is capable of producing significant outperformance. In the summer of 2007, Goldman Sachs introduced GS Sustain, a focus list of companies that the analysts believe are attractive from an integrated ESG/financial perspective. While Goldman Sachs states that ESG analysis alone does not add value, the integration of ESG with financial metrics does: GS’s identified “winners” outperformed the MSCI World index by 25% over the two years between summer of 2005 and summer of 2007.3
A brand-new report from the United Nations Environment Programme Finance Initiatives4 reinforces the findings of groups like Innovest, Watson Wyatt, and Goldman Sachs. This report, written by Mercer (a well-respected investment consultant) reviews 20 academic studies and 10 broker studies that examine the impact of ESG variables on financial performance. The academic studies chosen all met several criteria, including publication in peer-reviewed journals, considered a good representation of ESG factors using different research methods, and were considered influential in the newly-developing field of examination of extra-financial factors as applied to traditional finance theory. Of the 20 studies, half found that good ESG performance was positively related to financial performance, 7 found no significant effect (e.g., no difference in the performance of portfolios incorporating ESG factors, compared with more traditionally constructed portfolios), and 3 found a negative association. Those proportions are generally reflective of the wider literature examining the financial-performance impacts of environmental, social, and governance factors.
The preponderance of the literature examines performance in just one dimension: returns. This is true of the literature that addresses investment performance as well as the literature that addresses stock price performance or the return-on-something (equity, assets, what have you) of individual companies. The tendency in such studies is to focus on what we in the investment world call alpha: the return on a portfolio compared with a benchmark index, or an equilibrium model prediction like the capital asset pricing model. But return is not the only measure of an investment portfolio’s performance, nor is it the only characteristic investors care about. Another important factor is risk, and investors have widely differing appetites for risk – some preferring relatively less risk while others prefer more. The more risk investors take, the more they expect to be paid for it—and the term we use to describe portfolio risk is beta.
Incorporation of ESG factors is starting to look equally interesting from the standpoint of risk, or beta, as it does from a strictly-returns point of view. Though this literature is not yet as voluminous as that focusing on returns, the papers that do exist are beginning to point in similar directions. Work being described in two forthcoming papers by Mark Sharfman, a professor at the Michael F. Price College of Business at the University of Oklahoma, shows that firms with better social and environmental performance tend to have lower costs of capital as a result of the lower risks associated with better environmental and social management. This is consistent with earlier work done by Becchetti and Ciciretti that concludes that social responsibility lowers risk at the individual-stock level and results in no significant differences in risk-adjusted returns between a socially responsible portfolio and a control sample.5
There are a great many ways to prime the research pump to get an answer that comports well with the world view of the researcher or institution in question, although probably not as blatantly as the old joke about the economist who, in response to the question “what’s 2 + 2”, responds with “what do you want it to be?” For example, a recent major daily newspaper recently ran a story about SRI showing that SRI funds had underperformed large and mid-cap unscreened peers over a recent twelve-month period. This was taken as proof, at least by the story’s author, that investing “with a conscience” comes with a financial price tag. But as investors know, market cap is only one attribute of an investment portfolio; others include style (growth, value, core), geography (domestic, international), and other elements of financial discipline (e.g., long-only vs. long-short, equity, fixed income, balanced). Social funds come in dozens of flavors, including value, growth, core, long, long-short, domestic, international, global, equity, fixed income. The fact that over one selected year some SRI funds didn’t perform as well as some other funds along a single dimension—market cap—proves exactly nothing. Give me a one-dimensional problem and an unlimited selection of time periods and I can “prove” just about anything. But it’s just about as persuasive as the famous “proof” that 2 = 1, which anyone curious to see how to do it can view on Wikipedia.6 There is a logical fallacy in this “proof,” just as there is in the news article about SRI funds. Dividing by zero (the problem in the 2 = 1 example) is the investment equivalent of comparing funds across investment disciplines (which is perfectly legitimate) and drawing sweeping conclusions about the performance of one or the other based on such thin evidence.
I’m an economist too (I confess), but at least I know better than to fall for the “what do you want it to be” school of investment research.
1Watson Wyatt, “What is? Sustainable Investment,” January 2007.
2Jeroen Derwall, Nadja Guenster, Rob Bauer, and Kees Koedijk, “The Eco-Efficiency Premium Puzzle,” Financial Analysts Journal (61:2), 2005.
3Goldman Sachs Global Investment Research, “Overview: Introducing GS SUSTAIN,” July 2, 2007.
4United Nations Environment Programme Finance Initiative Asset Management Working Group and Mercer, “Demystifying Responsible Investment Performance: A Review of Key Academic and Broker Research on ESG Factors,” October 2007.
5Leonardo Becchetti and Rocco Ciciretti, “Corporate Responsibility and Stock Market Performance,” Centre for International Studies on Economic Growth Research Paper Series, Working Paper No 79, March 2006.
6Wikipedia, “Invalid Proof,” posted at http://en.wikipedia.org/wiki/2%3D1#Proof_that_2_.3D_1.