Jeff Brown in the Washington Post business section discusses “socially responsible” investing, the practice of restricting the domain of one’s portfolio to support various causes. Brown provides estimates of how much return on investment soc ially responsible investors sacrifice to pursue their social goals.
Brown’s article is remarkable because it is one of few to acknowledge that the imposition of political or social constraints generally leads to lower returns. Investors with strong political or social values can choose to accept lower returns. The problem is mutual funds that promote social causes often imply in their advertising that their returns are just as good as mutual funds that do not impose such restrictions. In other words, they imply there is either no opportunity cost to “socially responsible” investing, or the opportunity cost is minor.
Brown provides some data that put these opportunity costs in perspective. His data, which he attributes to Morningstar, suggest that the opportunity costs of socially motivated investing can be very large. And it’s not clear what benefits investors actually get in the process.
First, a sidebar explanation.
We prefer to call this practice socially motivated rather than socially responsible or socially conscious investing. The latter terms are judgmental, not descriptive. Investors may well disagree completely about the social values they want to advance (or retard). But investors with opposite and incompatible values cannot both be investing “responsibly.” On the other hand, all investors who choose to constrain their portfolios to include or exclude certain assets for social reasons can be understood as acting in a socially motivated manner.
The print edition of the Post includes in graphical form the following data comparing returns in socially motivated investment with returns in portfolios that are not constrained by social values. We’ve added to the data from Post chart our calculations of opportunity cost expressed as reduced rate of return.
|5-Year Average Total Returns for Mutual Funds
(Opportunity Cost Expressed as Reduced Rate of Return with Respect to Selected Baseline)
|Large Cap||Mid Cap||Small Cap|
|All||7.7% (-6.5%)||10.3% (-26%)||10.2% (-67%)|
|S&P 500||8.5% (-15%)||—||—|
Although the Post identifies the source for its figures, it does not reveal how they were calculated so we are unable to reproduce their results. Moreover, there are other useful benchmarks besides 5-year rates of returns, most notably estimates of fund volatility. Taking them at face value, it appears that the opportunity cost of socially motivated investments is much smaller for portfolios consisting of very large companies.
In the print version the Post provides links to three websites promoting socially motivated investment, each of which we reviewed. (We could retrieve only a cached website from socialinvest.org.) All advocate modern liberal social causes such as environmentalism, gay rights, and businesses allied with the Democratic Party; and opposition to nuclear power and weapons, animal testing, and tobacco. We found linksfor reporters who need anecdotes and lack the time, energy or expertise to perform their own research.
None are transparent about the opportunity costs of socially motivated investments, such as comparisons of the form provided by the Post accompanying Brown’s article. This begs the question whether socially motivated investors are fully aware that their investments earn lower returns — spectacularly lower in the case of small cap funds, if Brown’s data from Morningstar are valid.
The Post also links to Morningstar, an independent investment service. Morningstar provides more objective reviews and does not take sides with respect to which social values investors should hold. Thus, its articles are useful for a broader array of socially motivated investors, including those with religious rather than political values. Morningstar also is more revealing about opportunity costs. It compares returns from socially motivated funds and broader market alternatives. Laggard blue chip returns appear to be caused by the exclusion of firms in natural resource extraction. Mid- and small-cap returns have “uninspiring long-term records or unattractive expense ratios.” Investments in international stocks appear to be handicapped by screens that demand third world companies abide by first-world labor and environmental standards.
Brown’s article — both the online and print versions — is accompanied by stock photographs that establish an emotive link with the cause being promoted, thereby stimulating greater willingness to pay the opportunity costs associated with promoting the cause. An example is the nearby polar bear photo, which in the print edition is linked without explanation to global warming. In the online version, the photo’s caption reveals the absence of a factual linkage but anchors the emotion more strongly in political advocacy.
|“This is an undated handout photo of a polar bear taken in the Artic [sic] National Wildlife Refuge. Museum-goers in San Francisco will soon get an uncensored look at Alaskan wilderness photos that ignited a minor uproar in the nation’s capital this spring. The new exhibit features 49 photos of the Arctic National Wildlife Refuge – 19 million acres of pristine wilderness at the center of a fierce debate between environmentalists and the Bush Administration. (AP Photo/Subhankar Banerjee) (By Subhankar Banerjee — Associated Press”|
From a regulatory economics perspective, is this a market failure? Does it matter if socially motivated mutual funds do not make transparent the precise criteria and data they used to include or exclude a stock, or the opportunity costs of the criteria they apply? Assuming that they disclose the same information that traditional mutual funds reveal, typically to comply with regulatory requirements, should they be required to also disclose the exact screens they used to select investments and report the financial consequence of each one?
The obvious answer is “no” because even traditional mutual funds utilize screens of various types to decide which stocks to buy, sell and hold. These screens are proprietary, and requiring their disclosure would undermine the intellectual property rights of those who worked to develop and perfect the screening tools. Investors are free to choose which funds they buy, but should not be free to expropriate assets.
But a case can be made that socially motivated funds should reveal much more information. Unlike traditional mutual funds, whose managers make claims about their performance as portfolio managers, managers of socially motivated funds make specific claims about the character of the companies in which they invest. Whereas the performance of traditional fund managers can be measured based on investment performance, socially motivated fund managers must be gauged primarily on the veracity of the claims they make about their portfolios, and only secondarily on investment returns — which, after all, are expected to be lower. (Greater fidelity to principle in asset selection also may be inversely correlated with returns on investment. That is, the more demanding the fund’s social principles the greater will be the opportunity cost of investing in adherence with these principles.)
The need for better disclosure is especially so for socially motivated funds that place a high value on corporate transparency. It would be highly ironic if managers of socially motivated mutual funds demanded a high level of transparency from the firms in which they invested, but did not adhere to the same standards when it came to their own customers.