The growth of economically targeted investments and socially screened funds has its basis in the popular perception that the unconstrained maximization of investment returns does not serve the greater good.
Exactly how much serving the greater good costs investors remains unanswered, but a growing contingent of social investing advocates argue that doing good need not preclude doing well.
Some even make the counter-intuitive claim that restricting the investment universe, via social screens actually can increase risk-adjusted portfolio performance.
Statistical studies comparing the risk-adjusted return performance of ETIs and social funds serve a useful purpose. But they also can obscure other relevant questions - do the benefits of social investing exceed the costs? Are there more efficient alternatives to social investing?
Most empirical studies only examine the "opportunity cost" of social investing (i.e., the risk/return trade-off of social screens vis-a-vis some benchmark) and ignore the social benefits.
The logic of efficient markets would suggest some socially conscious investors might be willing to forgo higher private returns if investments generate superior social returns. Alternatively, if the net social benefit is zero, fretting over the private risk/return trade-off between social investing and a benchmark is a waste of time.
If social investing is to be more than an exercise in self-righteous posturing, money managers should attempt to provide investors objective evidence on "social benefits" as well as their "opportunity cost." Some might contend that those who justify substandard private returns on the basis of unsubstantiated social benefit are perpetuating a ruse on their clients. Good intentions, however noble, should not be substitute for performance.
Much of the ambiguity surrounding social investing springs from the failure to rigorously identify its objectives. Too often, advocates defend social investing with vague homilies on social responsibility, while opponents cynically dismiss the practice even though social investing may play a prominent role in ending morally reprehensible social practices such as apartheid.
Economic theory can shed a little light on the social investing controversy.
Two sides of one coin
Leaving the terminology debate to lawyers and linguists, economic theory interprets ETIs and social screens as different sides of the same social investing coin.
Socially screened stock funds exclude equities based on a variety of criteria including companies that produce and market alcohol, tobacco, nuclear power, gambling, military hardware and products regarded as potentially harmful to the environment. In the jargon of economics, these industries are believed to generate "negative externalities" because society incurs a substantial portion of the costs associated with their production and consumption. If producers were required to bear all of the costs, these products would sell for a higher price and a smaller quantity would be produced.
ETIs are the flip side of the coin. ETI projects are thought to generate "positive externalities," meaning a substantial portion of the benefits accrue to society at large. Even though the public benefit might be great, consumers are more concerned with maximizing private welfare. Because consumers are unable to capture public benefits, products that generate positive externalities will tend to be underproduced.
Assessing 'externalities'
One strategy to recoup some of the social costs of negative externality products, like tobacco and alcohol, is to impose a tax on their manufacture and sale. Similarly, products perceived to generate positive externalities, like housing and education, can be subsidized via deductions, low interest rate loans or direct cash payments.
Rather than directly affecting product price, social investing attempts to influence the weighted average cost of capital and increase or decrease real investment opportunities. By denying funds to companies that generate negative externalities, social screens hope to increase the weighted average cost of capital and decrease new investment.
In contrast, ETIs attempt to increase the availability of capital to projects that generate a positive externality, decrease the weighted average cost of capital, and increase the dollar amount of new investment.
Are social screens effective? At the margin, firms probably mitigate any increase in the cost of equity by substituting alternative financing. To complicate matters, most economists would take the politically incorrect position that there is a "socially optimal" level of consumption for products like alcohol and tobacco that enhances the greater good and does not result in any negative externality. Social welfare actually would be diminished if responsible consumers were denied the occasional brandy and cigar.
In an attempt to appeal to the broadest social spectrum, the economic impact of many social screens tends to be diffused.
Is there any reason to presume that those who wish to avoid investing in nuclear power also abhor alcoholic beverages? Taxes might also play a role. Contributions to non-profit social advocacy groups are generally tax deductible, while the returns to social investing are taxable. Investors might achieve a more efficient social result by maximizing private returns and then donating the difference to specific advocacy groups, such as Mothers Against Drunk Driving, that are able to document impressive social performance.
What is significant?
Proponents of social screens frequently justify substandard performance by arguing the annual return differential between the benchmark and the screened portfolio is "not substantial" or "statistically insignificant."
In most cases, annual return comparisons have statistical merit because there is the inherent presumption that investors have the option of moving in/out of the higher/lower return asset as the expected trade-off narrows and widens. Because investment screens assume negative externality stocks are forever blocked from the investment universe, they become an irrelevant intermediate alternative.
Rather than annual returns, differences in terminal values over the investment horizon might be a more appropriate mode of comparison.
For example, the College Retirement Equities Fund's Social Choice Account had a five-year equity return equivalent to 12.41% vs. the 13.58% return for CREF's Stock Fund equity component for the five years ended Dec. 31.
A social investing advocate might conclude that on an annual basis, the social screen has "not substantially underperformed" the unscreened equity component (Pensions & Investments, Feb. 17). However, based on five-year averages, the terminal value of $1,000 over 20 years is $10,378 for the screened portfolio and $12,765 for the unscreened.
Most retirees would consider the 23% difference in the terminal value "substantial."
One redeeming feature
Whatever criticism one might direct at social screens, their redeeming feature is that they tend to be voluntary.
In contrast, ETIs frequently are imposed on public pension programs by a variety of political bonds. Their philosophical origins can be traced to the "industrial policies" programs, termed "lemon capitalism" by cynics, that once plagued many European economies.
Compared to social screens, evidence documenting the relative risk/return performance of ETIs is even more ambiguous. Not everyone agrees on the benchmark, risk adjustment, or what constitutes an "ETI" because the terminology frequently is altered to keep opponents off-balance.
Rather than defining ETIs in the context of net social benefits, ETIs have come to mean "local" investing. In many respects, they are motivated by the same parochial anxieties that spawned the 1977 Community Reinvestment Act in banking.
One method for camouflaging the lower risk-adjusted returns to ETIs is to package them in government guaranteed loan pools and transfer part of the risk to taxpayers.
While government guarantees might render ETIs more palatable to investors, they resurrect the "moral hazard" problem reminiscent of bank deposit insurance. Because the riskiest ETIs obtain the greatest benefit from guarantees, inferior ETIs might be inclined to gravitate to insured pools, increasing the contingent liability of taxpayers.
ETI supporters claim the investments fund local projects that otherwise would be ignored, and that promotes market efficiency by filling "gaps" in the financial system.
Irony of backers' argument
The cause and effect probably are reversed.
Technology and efficient markets have reduced investor dependence on the local economy and made it easier to deploy capital in distant regions. Most often, the thrust of both ETI and CRA is to reverse the trend in geographic efficiency and reallocate more capital to the local economy even though the return might be lower and the risk higher.
Those who assert the risk-adjusted returns to ETIs equals or exceeds other alternatives inadvertently make the most compelling case against the need for targeted investments.
Even though the net social returns might be negligible, many people still might get a great deal of personal satisfaction from social investing. Like the recycling of household solid waste, social investing makes the most economic sense if investors derive "utility" from the practice and choose to subsidize it because it makes them feel good.
The operative word is "choice."
When social investing is imposed on public pension funds because local politicians want to fund new sports stadiums or other "infrastructure," the economic outcome is much more likely to be perverse.
Michael Devaney is a professor in the department of accounting and finance, Donald L. Harrison College of Business, Southeast Missouri State University, Cape Girardeau, Mo.
