Spend any time talking about responsible investing, and quickly the conversation turns to whether it hurts or helps returns.
The answer is neither, as I argued in a blog post last fall. But this discussion always comes from the perspective of relative returns—that is, whether responsible investing can help an investor outperform a benchmark. What we never ask is perhaps a more interesting question: Could responsible investing improve the return of the benchmark itself? And wouldn’t that in turn help all investors?
This question is especially relevant for so-called passive investors—those who are trying to be the market instead of beat the market. In a world that justifies responsible investing only on the basis of relative returns, there’s no room for such an investor. Which is a shame, given the potential benefits of improving returns on a universal basis. But it doesn’t have to be this way.
To examine the topic further, let’s draw a distinction between active investors on the one hand and passive investors on the other.
Living in a world of relative returns
Let’s say you’ve identified an issue as being financially “material” to a public company. That is, you believe it will affect the company’s revenues or costs and therefore its intrinsic value. But this is only the beginning of the game. If your beliefs are in line with investor consensus and this issue is “priced” into the stock, there’s nothing to do. It’s only when you’ve identified what you believe to be an underpriced (or overpriced, if you intend to go short) security that it’s time to trade. And it’s only when your bet proves out and the security increases in value more than the benchmark average that your efforts are justified.
This is the active investor’s path to success in the world of relative returns, whether you describe your approach to determining financial materiality as “responsible investing” or not. The payoff comes only from owning a portfolio that differs sufficiently from the benchmark and consistently contains stocks with above-average returns.
The situation is very different if you choose to simply own everything and not worry about outperforming the benchmark. In this case you could take the same financial materiality analysis and use it not to decide whether to own a given stock but rather—through active ownership—to encourage the laggards to become better and the leaders to continue gaining ground. If successful, this could make any of the companies in the benchmark worth more than they would have been otherwise.
The bottom line
Active ownership can’t make miracles happen. And it can’t prevent all bad things. But shareholders successfully pressuring public companies to address material risks could help increase overall market returns. This would reward both passive and active investors, who could continue to add excess return to an even higher base level. It may be hard to measure, but it seems like that must be worth something.