Socially responsible investing, at least in the form of screens, limits an investor’s universe of equities, so therefore it must put a crimp in portfolio performance, right? This line of thinking, once common among investors and commentators, is rarer these days. But we do still get questions from investors and advisors concerned that socially responsible investment performance as a result of screening means weaker portfolio returns.
While we’re skeptical of claims that screening according to your values is a source of reliable outperformance, we’re equally skeptical of the opposite claim: that portfolios based on “virtue” are a path to underperformance. We reject this claim on both empirical and theoretical grounds.
Socially responsible investment performance: What do empirical studies reveal?
From an empirical perspective, outside studies of the impact of responsible investing on performance have historically suffered from underlying flaws that weaken their conclusions. These flaws include aggregating results into a single data set despite meaningful differences in criteria, underlying exposures, or portfolio-construction techniques.
Some studies also fail to separate out the impact of systematic biases in the ESG portfolio on performance. For example, an underweight to energy and an overweight to information technology is a common sector positioning in ESG strategies. While this has been a good bet in recent years, it’s not clear that this should be considered a persistent source of ESG outperformance going forward.
Finally, many studies don't follow conventional statistical practices, such as evaluating data with an insufficient number of observations. All of which is to say that we have yet to see convincing empirical evidence that screening is reliably helpful or unhelpful for performance.
What about the supply-and-demand argument?
Another line of thinking we’ve heard is that portfolio screening skews the supply and demand curves for the stocks of “sinful” companies. This argument posits that, because so-called virtuous investors reduce the demand for a stock, it’s left to the “amoral” investors to purchase the stock—and they get to do so at a lower price, thanks to the reduction in demand from virtuous investors. Which in turn means they can expect a higher return on their investment.
Yet as all econ geeks know, real supply and demand curves come in all sorts of shapes. Given this, a reduction in demand for a stock for ethical reasons can produce a big change, a little change, or no change at all in the clearing price, depending on the shapes of the curves. However, in our experience, there’s no consensus on what, in investors’ minds, constitutes “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 at any minute, sometimes dramatically, up or down. This complicates any efforts to decisively answer the question about the impact of screens on portfolio returns.
Putting performance to the test
As of September 30, Parametric manages more than 2,000 responsible-investing accounts, with every kind of ESG criteria you can imagine. We have yet to see any compelling evidence that the excess returns (positive or negative) from screened portfolios are statistically different from zero.
For example, one of our most popular screens is for investors seeking to avoid fossil fuels in their portfolios. As you can see from the chart below, removing fossil-fuel owners from the S&P 500® Index produces excess returns that very closely track the benchmark.
Source: FactSet, Fossil Free Indexes as of 12/31/2017. Excludes the largest owners of coal, oil, and gas reserves as determined by Fossil Free Indexes. Hypothetical performance is for illustrative purposes only, does not represent actual returns of any investor, and may not be relied on for investment decisions. Actual client returns will vary. All investments are subject to loss. Indexes are unmanaged, cannot be invested in directly, and do not reflect the deduction of fees or expenses.
The bottom line
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. In our experience, there’s little evidence that screens should result in either persistent underperformance or outperformance.
Potential Parametric solution
For more than 20 years, our Responsible Investing capability has offered a robust and continually evolving menu of ESG screens and licensed indexes, giving investors a wide range of portfolio design choices. In addition, our proxy-voting guidelines follow corporate-governance best practices to safeguard shareholder capital, and they consider the relevant environmental and social implications of management and shareholder proposals.
Jennifer Sireklove, CFA, Managing Director, Investment Strategy
Jennifer leads the Investment Strategy Team at Parametric, which is responsible for all aspects of Parametric’s equity-based investment strategies. In addition, she has direct investment responsibility for Parametric’s Emerging Markets and International Equity strategies and chairs Parametric’s Stewardship Committee. Previously she helped build Parametric’s active ownership and custom ESG portfolio construction practices. Prior to joining Parametric in 2013, she worked in equity research, primarily covering the energy, utility, and industrial sectors at firms including D.A. Davidson and McAdams Wright Ragen. Jennifer earned an MBA in finance and accounting from the University of Chicago and a BA in economics from Reed College. A CFA charterholder since 2006, Jennifer is a member of the CFA Society of Seattle.
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.