Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that you are 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 that rely on animal testing as part of their research and development efforts. Other investors may also be concerned about social, environmental, governance, labor or religious issues. It is important to note 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.
According to the 2012 annual report of The Forum for Sustainable and Responsible Investment, total SRI assets in the United States rose from $639 billion in 1995 to $3.74 trillion at the end of 2011. Clearly investors believe in SRI.
One question for investors in SRI funds is: Is there a price to pay for avoiding “sin stocks”?
To answer the question, we begin by considering that SRI funds are typically more expensive than index funds and passive funds in general. One reason is that they incur the extra costs of screening out the undesirables. Those extra costs hurt returns.
SRI investors also typically sacrifice diversification. SRI funds typically are domestic and large cap. Thus, investors sacrifice exposure to small and value stocks, and perhaps international and emerging market stocks as well. They also then lose exposure to the higher expected returns provided by small, value and emerging market stocks.
SRI investors also may be accepting other risks. Because they avoid investing is “sin” stocks, they are not fully diversified across industries.
There is one other important point to consider. Economic theory tells us that because there are $3.7 trillion of SRI investments that avoid “sin” stocks, the cost of capital of sin stocks is driven higher than it would otherwise be, and the cost of capital of the non-sin stocks is driven lower. In other words, by avoiding investing in sin stocks, investors make those stocks cheaper (smaller and more value-oriented). And since the flip side of the cost of capital is the expected return to investors, SRI investors are missing out on the higher expected returns of “sin” stocks.
The authors of the study, “The Price of Sin: The Effects of Social Norms on Markets,” provide evidence that supports the hypothesis of there being a societal norm against investing in “sin” stocks, and that it does impact the cost of capital. The following is a summary of their findings:
The conclusion we can draw from this study is that social norms have important consequences for the cost of capital of “sin” companies. They also have consequences for 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 that’s 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 most about and get a tax deduction at the same time.