There has been some buzz lately about whether virtue, in the form of socially responsible investing, and outperformance are mutually exclusive. While we are skeptical of claims that investing according to your values should be a sure-fire source of outperformance, we are equally skeptical of the opposite claim: that portfolios based on “virtue” should be a guaranteed source of underperformance. We reject this claim on both empirical and theoretical grounds.
From an empirical perspective, outside studies of the impact of responsible investing on performance tend to be flawed by blindly aggregating and attributing all return differences to responsible investing for portfolios with completely unrelated environmental, social and governance (ESG) criteria, exposures, or construction techniques: apples to oranges. They also mostly fail to explore the impact of stock picking or systematic biases on performance. Finally, poor statistical techniques, including evaluating data with an insufficient number of observations, are often present. Therefore, we have yet to see convincing empirical evidence that responsible investing is reliably helpful or unhelpful for performance.
From a theoretical perspective, as all econ-geeks know, real supply and demand curves come in all sorts of shapes. Given this, a reduction in demand for ethical reasons can produce a big change, a little change, or no change at all in the clearing price, depending on the shape of the curves. However, in our experience, there is no consensus on sin, or “virtue”! This vastly limits the reduction in demand. Furthermore, any change in demand from virtue is likely to be completely swamped by changes from company valuations. These valuations are the primary driver of supply and demand curves for a company’s stock and can change any minute, sometimes dramatically, up or down. This complicates any efforts to decisively answer the question about the impact of responsible investing on portfolio returns.
We currently manage over 1,400 responsible investing accounts*, with every possible kind of ESG criteria you can imagine. And I have yet to see any compelling evidence that the excess return from these responsible investing portfolios is statistically different from zero.
Pop quiz: Can you tell which of these portfolios is fossil free and which is its unscreened benchmark?
- Hypothetical Portfolio A: 7.44% return, 13.9% volatility
- Hypothetical Portfolio B: 7.35% return, 14.1% volatility
- Hypothetical Portfolio C: 5.03% return, 17.1% volatility
- Hypothetical Portfolio D: 5.13% return, 17.0% volatility
Evaluating one’s options and implementing responsible-investing mandates is a complex process and owning a portfolio that differs from the benchmark will always introduce the potential for return differences. In the absence of omniscience, we advise investors to seek clarity by understanding the potential magnitude rather than the direction of differences. But know that it is just as foolish to count on underperformance from screens as it is to count on outperformance.
Answer: Portfolios B and D, market cap weighted S&P 500® or MSCI EAFE Indexes ex Carbon Underground 200, respectively. Portfolio B had slightly lower performance and higher volatility compared to Portfolio A, which is just the S&P 500. Portfolio D had slightly higher performance and lower volatility compared to Portfolio C, which is just the MSCI EAFE Index. Jan 2004 – December 2016, annualized return numbers.
Potential Parametric Solution
Parametric has been offering client-driven, index-based portfolios that incorporate ESG criteria for more than 15 years. Our robust and continually evolving menu of ESG screens and licensed indexes gives investors a wide range of portfolio design choices. In many cases, however, investors are well served by a standardized portfolio with minimal modifications. With this in mind, we’ve designed a series of risk-controlled, index-like exposures that can be used as a core equity portfolio allocation while aligning with common responsible investing themes.
An Acronym-Free Introduction to Responsible Investing
In our latest post, Jennifer Sireklove explains — in plain English — environmental, social and governance-focused investment approaches. Learn about the three investment objectives and the two options available to achieve those objectives.
Understanding The Difference Between ESG Screens and Tilts
Responsible investing is an evolving space that covers a diverse set of considerations and priorities. A screen builds a portfolio out of a subset of the eligible investment universe that meets specific environmental, social and governance (ESG) criteria.
Jennifer Sireklove, CFA - Director of Responsible Investing
Ms. Sireklove oversees all aspects of Parametric’s Responsible Investing Strategies. As the primary strategist for responsible investing, Jennifer works closely with advisors and consultants to design, develop and implement portfolio solutions that incorporate their clients’ principles.
Index performance is hypothetical and is provided for illustration purposes only; it does not represent the performance of any investor or strategy offered by Parametric. Index performance does not reflect the deduction of advisory fees or brokerage commissions, which would reduce the returns presented. It is not possible to invest directly in an index.
*As of June 30, 2017
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.