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Environmental, Social, and Governance and Socially Responsible Investing

     Socially responsible investing (SRI) is a general term used to describe investments that reflect good values, morals, and ethics. Environmental, social, and governance (ESG) is a similarly used description that has become more common recently. In addition to earning competitive rates of return on their money, those who invest in a socially responsible manner attempt to improve the world by investing in companies that function in an ethical manner. SRI is sometimes described as the attempt to "do good while doing well."

     Forms of socially responsible investing may date back more than several hundred years with many early cases having religious origins. In the 1700s, John Wesley (the founder of Methodism) taught about the importance of money, and the Quakers who settled North America avoided slavery and weapons related investments. More recently, the avoidance of companies dealing in South Africa represented a driving force behind socially responsible investing and many believe it played a significant role in Nelson Mandela's rise to power. Islamic finance also provides guidance regarding preferred investments and practices to be avoided.

     SRI criteria can include positive screens (for considering targeted investments in companies that focus on doing good), as well as negative screens (for eliminating companies from an index or broadly diversified portfolio) that are considered harmful. A United Nations Environment Program formalized in 2006 called “Principles for Responsible Investment” provided a framework for investors using environmental, social, and governance factors in the investment process.

     Common screens used by socially responsible investors often include the following.

     Funds invested according to some kind of socially responsible screen have grown dramatically in the last few decades. There are now hundreds of funds that use some kind of screening. The longest-running SRI index started in 1990 as the Domini 400 index fund, before being renamed the MSCI KLD 400. It has had high correlation, overlap, and similar performance to the S&P 500. Vanguard introduced U.S. and international ESG ETFs in 2018. ESGV and VSGX have expense ratios of 0.12% and 0.15% and both already have hundreds of millions of dollars in assets. Deutsche Bank launched a US ESG ETF (USSG) in March 2019 with an expense ratio of 0.10% (raising over $800 million from a pension-insurance company in Finland).1

     The decision to deviate from a default or complete index for moral or socially responsible reasons is a personal decision for individual investors. If you are troubled by investing in companies that you are not comfortable with, it makes sense to investigate options that will make you more comfortable, and the follow-up question is whether you may be increasing your risk and/or reducing your expected returns in the process.

     Public pension funds and many varieties of investors have been debated the pros and cons of SRI investing for decades. Meir Statman summarized in his book What Investors Really Want that “investors must weigh the potential loss of returns and diversification benefits from avoiding screened investments versus the utilitarian, expressive, and emotional benefits." Statman coauthored an early study on the topic in 1993 which analyzed 17 socially responsible mutual funds that had been established in 1985 or earlier. The authors concluded in the article that the performance of the funds was not statistically different from conventional funds and that "Investors can expect to lose nothing by investing in socially responsible mutual funds; social responsibility factors have no effect on expected stock returns or companies' cost of capital."2

     Statman coauthored another paper in 2016 after studying 20 years of data (adjusting for common factors) and found that mutual funds improve performance by holding companies that score high in five social responsibility categories, but offset this increase by shunning companies in certain industries, which decreases performance and results. Overall they found no significant difference in returns for socially responsible investing.3

     In 2015, researchers at Deutsche Asset & Wealth Management and Hamburg University conducted a meta-analysis of over 2,000 empirical studies since the 1970s. “The results show that the business case for ESG investing is empirically very well founded. Roughly 90% of studies find a nonnegative ESG–CFP relation. More importantly, the large majority of studies reports positive findings.”4

     In 2016, Barclays published a report titled "Sustainable Investing and Bond Returns." They applied either a positive or negative tilt to different ESG factors relative to the Bloomberg Barclays US Investment-Grade Corporate Bond Index and found that “…a positive ESG tilt resulted in a small but steady performance advantage…” They did not find evidence of negative performance.5

     In 2017, Nuveen TIAA Investments released “Responsible Investing: Delivering Competitive Performance.” After assessing the leading SRI equity indexes over the long term, the firm “found no statistical difference in returns compared to broad market benchmarks, suggesting the absence of any systematic performance penalty. Moreover, incorporating environmental, social and governance criteria in security selection did not entail additional risk.” The report added that SRI indexes had similar risk profiles to their broad market counterparts, based on Sharpe ratios and standard deviation measures.6

     A 2017 Financial Analysts Journal article also found no performance penalty for SRI mutual funds.7 Another Financial Analysts Journal article published in the fourth quarter of 2019 used new governance and ESG metrics to rank securities and found that investing in the top quartile universe over roughly the last decade would have outperformed (although the study did not include transactions costs and the time period studied was limited).8

     Not everyone agrees that investing for social impact makes sense and a recent article at CNBC stated “Impact investments have historically underperformed. For instance, the MSCI ACWI index returned an average of zero percent over the past decade.” The article included comments from Jack Bogle suggesting "It's far more effective to stop buying products from companies (investors want to make an impact on)."9 Harrison Hong and Marcin Kacperczyk studied returns from 1965 to 2006 and found that "sin" stocks outperformed by over 3% annually and they suggested they attract fewer institutional investors and less analyst coverage.10Eric Balchunas also pointed out early in 2020 that some ESG ETFs have underperformed, like SUSA, which "has trailed the S&P 500 Index by 37 percentage points during the past 10 years."11

     A 2018 Gallup poll suggested that SRI investing hasn’t affected most individual investors, given that only 10% say they have money invested in such funds. 34% had heard little and 40% had heard nothing about the concept of "social impact investing," while 33% said they were at least somewhat interested in investing in them.12

     Socially responsible investing topped $2 trillion in the United States in 1999, when one eighth of the funds under professional management in the United States were part of a socially responsible portfolio, according to the 1999 Report on Socially Responsible Investing Trends in the United States. According to the U.S. SIF Foundation's 2018 biennial Report, sustainable, responsible and impact investing assets expanded to $12 trillion in the United States (up 38 percent from $8.7 trillion in 2016). They identified assets under management at the outset of 2018 held by 496 institutional investors, 365 money managers and 1,145 community investing financial institutions.13

2. Sally Hamilton, Hoje Jo, and Meir Statman, “Doing Well While Doing Good? The Investment Performance of Socially Responsible Mutual Funds,” Financial Analysts Journal, November-December 1993
3. Meir Statman and Denys Glushkov, “Classifying and Measuring the Performance of Socially Responsible Mutual Funds,” Journal of Portfolio Management, Winter 2016
4. Gunnar Friede, Timo Busch, and Alexander Bassen “ESG and financial performance: aggregated evidence from more than 2000 empirical studies,” Journal of Sustainable Finance & Investment, 2015
7. Marie Brière, Jonathan Peillex, and Loredana Ureche-Rangau, "Do Social Responsibility Screens Matter When Assessing Mutual Fund Performance?" Financial Analysts Journal, Third Quarter 2017
8. Mozaffar Khan, “Corporate Governance, ESG, and Stock Returns around the World,” Financial Analysts Journal, Fourth Quarter 2019
10. Harrison Hong and Marcin Kacperczyk, “The Price of Sin: The Effects of Social Norms on Markets.” Journal of Financial Economics, 2009
11. Socially Conscious ETFs Have Some Baffling Holes, Bloomberg Yahoo, January 27, 2020

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Table of Contents and Launch Site

Last update 2/18/2020. Copyright © 2020 Gary Karz. All rights reserved.
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