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BAM Intelligence

Socially Responsible Investing Is A (Minor) Drag

Socially responsible investing, which is designed to address investors’ ethical and financial concerns, has gradually developed to include the consideration of firms’ environmental, social and governance (ESG) performance

An interesting question is whether ESG investing has an impact on risk-adjusted returns. It certainly can lead to less efficient diversification (due to screening out companies and even whole sectors of the economy).

Even if there are some negatives, it’s important to recognize that, for some investors, such financial consequences may not be very important. And they may not play a role at all. For them, their values have greater importance than maximizing risk-adjusted returns. Whether values or returns should drive investment is a very personal decision.

3 ESG Funds

With these issues in mind, we’ll examine three ESG offerings. To see the impact on risk-adjusted returns, we’ll use the regression analysis tool available at Portfolio Visualizer.

The first fund we’ll look at is Vanguard’s FTSE Social Index Fund (VFTNX). It has an expense ratio of 0.25% and, as of Aug. 11, 2016, had $2.3 billion in assets. For the period June 2000 through June 2016, a three-factor analysis (using AQR’s factors) shows that the fund generated a risk-adjusted alpha of -1.65% (t-stat of -1.76). A four-factor analysis (adding momentum) shows an alpha of -1.07% (t-stat of -1.24). And a six-factor analysis (adding quality and low beta) shows an alpha of -1.32% (t-stat of -1.43).

Also note that Morningstar shows that over the 15-year period ending Aug. 11, 2016, the fund returned 5.17%, underperforming the Vanguard 500 Index Fund (VFINX), which returned 6.12%, by 0.95 percentage points.

The second fund is the iShares MSCI KLD 400 Social ETF (DSI). The fund has an expense ratio of 0.50% and assets of just over $600 million. For the period December 2006 through June 2016, the three-factor analysis shows that the fund generated a small positive risk-adjusted alpha of 0.16% (t-stat of 0.12). A four-factor analysis shows exactly the same results. And a six-factor analysis shows an alpha of -1.26% (t-stat of -1.01). Over the latest five-year period ending Aug. 11, 2016, Morningstar shows the fund returned 14.91%, underperforming VFINX, which returned 15.56%, by 0.65 percentage points.

The third fund is the iShares MSCI USA ESG Select ETF (KLD). The fund has an expense ratio of 0.50% and assets of more than $415 million. For the period February 2005 through June 2016, a three-factor analysis shows that it generated an alpha of -0.98% (t-stat of -1.11). A four-factor analysis shows an alpha of -0.90% (t-stat of -1.03). Finally, a six-factor analysis shows that the fund produced an alpha of -1.71% (t-stat of -1.98, which is statistically significant at the 5% confidence level, though barely so). Over the latest 10-year period ending Aug. 11, 2016, Morningstar shows that the fund returned 7.32%, underperforming VFINX, which returned 7.89%, by 0.57 percentage points.


In summary, while all the results are over short periods, and we saw only one t-stat that was statistically significant, these results indicate there appears to be a financial price to pay for choosing the ESG route. And that price comes in the form of reduced risk-adjusted returns as well as less efficient diversification.

Ex ante, this outcome should not be a surprising one. If a group of investors shun stocks with certain characteristics and overweight others, the valuations of each will be impacted. The shunned stocks will have lower valuations (and thus higher expected returns); the overweighted stocks will have higher valuations (and thus lower expected returns).

 This commentary originally appeared August 26 on ETF.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

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Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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