A New Factor-Based Approach to Classifying and Measuring the Performance of SRI Mutual Funds
Larry Swedroe Jun 01, 2016
Meir Statman and Denys Glushkov contribute to the literature on SRI with their study, “Classifying and Measuring the Performance of Socially Responsible Mutual Funds”, which was published in the Winter 2016 issue of the Journal of Portfolio Management. Their contribution adds two social responsibility factors to the commonly used four-factor model (beta, size, value and momentum).
The first social responsibility factor they propose is the top-minus-bottom factor (TMB), consisting of relations, environmental protection, diversity, and products. The second factor is the accepted-minus-shunned factor (AMS), consisting of the difference between the returns of stocks of companies commonly accepted by socially responsible investors, and the returns of stocks of companies they commonly shun. Shunned stocks include those of companies in the alcohol, tobacco, gambling, firearms, military, and nuclear industries.
Statman and Glushkov built their social responsibility factors with data from the MSCI ESG KLD STATS database and note: “The two social responsibility factor betas capture well the social responsibility features of indices and mutual funds. For example, TMB and AMS betas are higher in the socially responsible KLD 400 Index than in the conventional S&P 500 Index.”
The authors’ study covered the period from January 1992 (when data first becomes available) through June 2012. To construct their two social responsibility factors, they calculated each company’s TMB-related score (total strengths minus total concerns) at the end of each year based on their set of five social responsibility criteria (employee relations, community relations, environmental protection, diversity, and products) and its AMS-related score, based on whether it is shunned or accepted. They then matched the year-end scores with returns in the subsequent twelve months.
The long side of the TMB factor is a value-weighted portfolio of stocks from firms that rank in the top third of companies by industry-adjusted net scores in at least two of the five social responsibility criteria and not in the bottom third by any criterion. The short side of the factor is a value-weighted portfolio of stocks from firms ranked in the bottom third of companies sorted by industry-adjusted net scores in at least two of five social responsibility criteria and not in the top third by any criterion.
Similarly, the long side of the AMS factor is a value-weighted portfolio of the accepted companies’ stocks, and its short side is a value-weighted portfolio of shunned companies’ stocks. The authors constructed the TMB and AMS portfolios as of the end of each year. The following is a summary of their findings:
- On average, the returns of the top social responsibility stocks exceeded those of the bottom social responsibility stocks. The TMB factor’s mean annualized return was 2.8%.
- On average, the returns of accepted stocks were lower than the returns of shunned stocks. The AMS factor’s mean annualized return was -1.7%.
- There was virtually no correlation of returns between the two factors.
- The six-factor alpha for the TMB factor was 0.55%, implying that social responsibility improves performance when it’s in the form of high TMB. The incremental alpha due to high TMB was generally statistically significant.
- The six-factor alpha for the AMS factor was -0.36%, implying that social responsibility detracts from performance when it’s in the form of high AMS. The negative alpha could be viewed as the price of avoiding “sin” stocks. However, the AMS score was not statistically significant.
- The difference in alpha is most pronounced when comparing funds with high TMB and low AMS betas to funds with low TMB and high AMS betas. The first group has high alpha and the second has low alpha. The difference in annualized alphas was a statistically significant 0.91%.
Statman and Glushkov concluded: “A lack of statistically significant differences between the performances of socially responsible and conventional mutual funds is likely the outcome of socially responsible investors’ preference for stocks of companies with high TMB and high AMS. The first preference adds to their performance, whereas the second detracts from it, such that the sum of the two is small. A proper analysis of socially responsible mutual funds’ performance requires separate accounting for the effects of TMB and AMS on performance.”
Their finding that the AMS factor produces negative alpha is consistent with both theory and prior research: if a large enough proportion of investors choose to avoid “sin” businesses, the share prices will be depressed. They will have a higher cost of capital because they will trade at a lower P/E ratio, thus providing investors with higher returns (which some investors may view as compensation for the emotional “cost” of exposure to offensive companies).
For example, Harrison Hong and Marcin Kacperczyk, authors of the study, “The Price of Sin: The Effects of Social Norms on Markets,” published in the July 2009 issue of The Journal of Financial Economics, found that for the period from 1965 through 2006, a US portfolio long sin stocks and short their comparables had a return of 0.29% per month after adjusting for the same four-factor model. As out of sample support, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a year.
As further evidence that avoiding sin stocks comes at a price, Elroy Dimson, Paul Marsh, and Mike Staunton also studied returns to sin stocks. Using their own industry indices that covered a 115-year period (1900-2014), they found that tobacco companies beat the overall equity market by an annualized 4.5% in the United States and by 2.6% in the UK (over the slightly shorter 85-year period from 1920 through 2014). Their study was published in the 2015 Credit Suisse Global Investment Handbook.
They also examined the impact of screening out countries based on their degree of corruption. Countries were evaluated using the Worldwide Governance Indicators from a 2010 study by Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues” (World Bank Policy Research Working Paper No. 5430). The indicators comprise annual scores on six broad dimensions of governance.
Dimson, Marsh, and Staunton found fourteen countries that posted a poor score, twelve that were acceptable, twelve that were good, and eleven with excellent scores. Post-2000 returns for the last three groups were between 5.3% and 7.7%. In contrast, the markets with poor control of corruption had an average return of 11.0%.
Realized returns were higher for equity investments in jurisdictions that were more likely to be characterized by corrupt behaviors. As the authors note, the time period is short and might just be a lucky outcome. On the other hand, it’s also logical to consider that investors will price for corruption risk and demand a premium for taking it. But it may also be a result of the same exclusionary factors found with sin stocks (investors boycott countries with high corruption scores, driving prices down, raising expected returns).
However, the finding of positive alpha for the TMB factor is a puzzle for the same reason that the negative alpha for AMS should be expected: if enough SRI investors shun stocks with low TMB scores, the cost of capital of such companies will rise, and so will their expected returns. Hence the apparent anomaly. A possible explanation is that perhaps the alpha could be explained by exposure to another factor (such as quality or low beta) not included in the four-factor model (beta, size, value, and momentum).
Other explanations can be found in the behavioral finance literature. For example, the 2011 study from Alex Edmans, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,” found that stocks of companies with highly satisfied employees earned higher returns than other stocks. The 2005 study, “The Eco-Efficiency Premium Puzzle,” by Jeroen Derwall, Nadja Guenster, Rob Bauer, and Kees Koedijk found that stocks of companies with good environmental records earned higher returns than other stocks. And the 2007 study by Alexander Kempf and Peer Osthoff, “The Effect of Socially Responsible Investing on Portfolio Performance,” found that stocks of companies that ranked high overall on community, diversity, employee relations, environment, human rights, and products did better than stocks that ranked low on those measures. In each case, higher returns could result from investor myopia — they tend to focus on possible negative short-term costs (such as higher wages) and underestimate long-term benefits.
The Bottom Line
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