Shooting Yourself in the Foot with Socially Responsible Investing

/Shooting Yourself in the Foot with Socially Responsible Investing

Shooting Yourself in the Foot with Socially Responsible Investing

By | 2017-08-18T16:57:00+00:00 January 31st, 2017|Guest Posts, Corporate Governance, $dsi|21 Comments

Socially responsible investing (SRI). Environmental, Social, and Governance investing (ESG). Impact investing…and so on…

These socially responsible investing concepts can be roughly described as portfolio strategies that allocate investment dollars based on ethical, social, sustainability, or other factors. This form of investment has become increasingly popular over the last decade (e.g., see the recent move by the Ritholtz gang into the space). Assets pursuing various flavors of these strategies are now measured in the trillions of dollars and index providers have been busy manufacturing products for this cause.

I respect the intention of those who pursue SRI and related approaches. If an investment approach makes one feel more comfortable with their portfolio and can improve their ability to maintain investment discipline, by all means — go for it. This post won’t debate the psychological benefits of the concept and won’t debate the performance characteristics of these approaches. Indeed, a significant amount of research has already been devoted to determining how these practices impact investment performance. Does investing with a conscience impose a cost on investors via dampened performance or does this form of investing reward investors with better returns? Thus far, the findings on potential cost/benefits appear mixed (see here and here examples of the debate). Notwithstanding, we believe there is a more important concern to be addressed:

Do socially responsible investment policies affect corporate decision-making?

This question is important for a large population of socially responsible investors because the intent of these investment approaches is often to influence corporate behavior (e.g., discourage investment in oil and more investment in solar energy). See the figure below for a visualization of the process of socially responsible investing and the potentially flawed logic that this investment approach will influence corporate behavior.

Figure 1: Flawed Transmission Mechanism


Source: Aaron Brask Capital

I’m going to make a claim that socially responsible investing has little to no impact on corporate behavior, and may in fact make the situation worse! This article discusses the problem and suggests one simple methodology to potentially address the issue.

Socially Responsible Investing Background

For the purpose of our discussion, we will use the phrase conscientious investing or investing with a conscience to describe those strategies integrating ethical focus, impact investing, SRI (socially responsible investing), ESG (environmental, social and governance), or similar factors into their investment policies. The basic logic behind these strategies is to use the practice of investing to support corporate practices or businesses one favors and/or avoid supporting those they do not favor.

There has been ample discussion of the performance implications of investing with a conscience. While I have not conducted a comprehensive survey of the research on this topic, it seems clear there is no universal agreement. Some studies find conscientious investing increases returns while others conclude its impact to be negative. I tend to fall into the negative camp for a few reasons:

  • Imposing constraints reduces the universe of stocks available to select from and this translates into less opportunity.
  • Many sin stocks fall into the value/contrarian category due to the negative stigma and some have been classified as being too risky (e.g., threat of litigation).
  • Analytical factor-based studies have normalized results for other drivers of return and indicated the negative impact to be statistically significant.

Whether or not the performance implications are positive or negative, I believe a more important issue has been taken for granted. In particular, how well does the practice of investing with a conscious target the intended businesses?

The Problem

Let us consider sin stocks as an example.(1) The overall purpose of avoiding investments in these stocks is to lower (or at least not help increase) their share prices and valuations. This translates into a higher cost of capital for those companies and thus raises the bar for them to raise money to fund their operations or new projects. This is assumed to have a negative (at least non-positive) impact on these companies.

There is a significant flaw in this logic, however. In particular, many companies tend to buyback their own stock. If the shares of a particular company are cheaper, this actually helps the company and its shareholders. Indeed, if the share prices are lower than they otherwise would have been, then these companies will spend less cash repurchasing shares or perhaps buy more shares back. In either case, the company and its shareholders benefit.

To be fair, it is possible that cheaper valuations might alter management decisions by attracting capital to the buybacks and away from the actual sin-related business operations. However, I find this logic to be a bit of a stretch. For example, there are many companies with long histories of reinvesting capital for growth while simultaneously rewarding shareholders via dividends and buybacks. It is possible the cheaper valuations allow them to purchase a fixed amount of shares with less money and allocate more to its core business activities. In general, I doubt buyback opportunities (often seen as tax-efficient dividends) would likely sway management in one of these companies away from productive capital investment opportunities.

Putting this together, it appears the conscientious investors who intentionally avoided purchasing the shares of sin stocks may have actually helped some of those companies who were repurchasing their shares.

Figure 2: Sin Stocks Tend to Re-purchase Their Shares


Source: Aaron Brask Capital

This leads to another question: Do sin stocks tend to repurchase their shares or not? We analyzed stocks trading on the New York Stock Exchange (NYSE). Judging by the number of shares of common stock outstanding, it appears over 70% of NYSE-listed sin stocks have been net (re)purchasers of their shares over the last three years. (2)

This calls into account the viability of many conscientious investing strategies. The assumed transmission mechanism may actually help the companies and shareholders of the very firms they intended not to support.

A Simple Fix?

Regardless of the objective or subjective criteria used to define which companies are favorable or unfavorable from a conscientious perspective, we suggest cross referencing the resultant list with another list depicting the magnitudes of corporate buyback activity.

The more general goal should be to help the good companies while not helping the bad companies. A sensible strategy might be to identify the capital needs (e.g., raising capital or returning capital via buybacks) of the targeted firms and make investment decisions contingent on this variable. The simple decision tree below illustrates one simple implementation of this framework.

Figure 3: Integrating Capital Needs


Source: Aaron Brask Capital

The figure above illustrates the decision process for integrating one’s views on corporate practices into their investment strategy. For example, consider a solar firm one wishes to support. If this firm is exploring and deploying new technologies, it will likely be raising capital. Accordingly, a conscientious investor might wish to purchase the stock since this will, in theory, help the firm by supporting its share price and reduce its cost of (equity) capital. On the other hand, if there is a more mature firm engaged in a less favorable business (e.g., tobacco) that is generating sufficient cash flow to support its growth while engaging in share repurchases, conscientious investors might consider allowing this firm into their portfolio. While it might feel counter-productive and weigh on one’s conscious from a psychological perspective, supporting the share price might actually make the buybacks more expensive and thus reduce the cash it reinvests in its unfavorable business activities.


Many investors use their investment dollars to target corporate practices they find particularly favorable or unfavorable. However, I find many such efforts may backfire and result in precisely the opposite of what was intended.

For example, one means of expressing one’s disapproval of a company’s corporate practices is to avoid purchasing that company’s shares. However, I find the majority of sin stocks listed on the NYSE tend to repurchase their shares. So lower share prices actually help these firms and their shareholders as it allows the firm to spend less money on buybacks and/or repurchase more shares at a lower price.

To date, I have not seen any press, research articles, or related discussions addressing this significant issue. This lack of consideration further supports my belief the investment industry is quick to tend to marketing demands of brokers and advisors rather than to performance and the needs of actual investors.

Fortunately, it appears there is a relatively straightforward solution. Index providers and practitioners pursuing such strategies can cross reference their lists of favorable and unfavorable companies with the corporate buyback activity of these firms to ensure their implementation of conscientious investing does supports or does not support the correct firms.

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References   [ + ]

1. We used NYSE-listed sin stocks as defined by
2. ibid.

About the Author:

Aaron Brask
Aaron is an accomplished Mathematical Finance PhD who runs his own registered investment advisor (RIA) - Aaron Brask Capital LLC. Before starting his own firm, Aaron's last role was at Barclays Capital where he built and ran two global research teams focused on quantitative equity and derivatives strategies for the firm's top clients. He has been published and quoted in major newspapers and magazines including the Wall Street Journal, Financial Times, Barron's, and Risk magazine. Aaron Brask Capital is an independent, fee-only registered investment advisor. That means I do not promote any particular products and cannot receive commissions from third parties. In addition to holding me to a fiduciary standard, this structure further removes monetary conflicts of interests and aligns my interests with those of my clients. In terms of spirit, my firm embodies my own ethics, discipline, and expertise. In particular, my analytical background and experience working with some of the most affluent families around the globe have been critical in helping me formulate investment strategies that deliver performance and comfort to my clients. I continually strive to demonstrate my loyalty and value to my clients so they know their financial affairs are being handled with the care and expertise they deserve.
  • Govind

    I see how buying the shares of good companies can help it reduce its cost of capital if enough investors do this. But I don’t see how buying the shares of mature bad companies can influence the business expansion of those companies. My understanding is that they make their investment decisions first, then use whatever is left over for paying out dividends or repurchasing their own stock. A lower stock price on the other hand might influence these companies into reducing their bad business practices and move toward more socially responsible ones.

  • Thank you for your comment.

    I do not think the decision process for capital allocation
    (investment vs dividends vs buybacks) is necessarily different for good
    versus bad companies. Moreover, it is not necessarily an either/or
    decision since higher quality companies (good or bad) can access debt
    markets to raise additional capital for investment or buybacks.

    To be clear, I am not saying buying or not buying shares of companies necessarily influences their business activities. In fact, I suspect there is a very weak link. I am pointing out how SRI and related strategies may actually benefit (fundamentally) precisely those companies they are trying not to support (and thus actually support their share prices over the longer term).

    Bottom line: I am surprised there is not more research into the efficacy of these strategies. Perhaps there was and it just got buried!

  • Would it be a better use of the socially responsible investor’s time to petition the government for a legislative fix to the perceived problem (or something similar)?

    Nick de Peyster

  • Hey Nick,
    Agree with your sentiment here. I’m sure there are many other approaches that would be more effective and efficient at accomplishing the mission to change corporate policy than one’s investment policy approach. For example, optimally investing to get mega-rich and then giving it all away to a charity that focuses on a specific lobby that targets a specific objective. Nonetheless, for those who are dead set on trying to noisily express their social views through their investment policy, this piece makes them question their process so they at least ensure that the approach they do take has a fighting chance of actually doing something productive.

  • Hi Nick,
    I agree with your sentiments, but those efforts take time whereas SRI and related strategies do not necessarily take up any of the investors’ time. They are offered more as a painless (you’re going to invest anyway) way to support a cause. Note: The jury is out, but I am not convinced they are painless as I suspect they very likely reduce returns.

    I am with Wes. If one is going to deviate from a market portfolio or other strategy, I would suggest deviating in the direction of value or other return-improving tilts where there is more conclusive evidence. Then they could donate the excess returns directly to causes they support and get tax deductions in the process.

  • Digitking

    I find the biggest problem with SRI mandates is that it’s all in the eye of the beholder. Obviously enviromentalists would advocate dumping mining and energy companies but where does it end? Do libertarian get voice to advocate dumping technology companies because they spy on you? What about labour groups, can they push to dump the low wage companies like Walmart or McDonalds? Even social conservatives would balk at investing in television studios (due to ties to pornography) or liquor companies.

    In short, the problem as I see is that you can line a pretty large constituency of people against any given industry which would leave you with nothing to left to invest in?

  • Interesting angle. Thanks for sharing. I don’t quite follow your last sentence though. Each constituency would avoid the sector they did not like; they would not necessarily avoid sectors others did not like. Taking this further, it might be the case that investors reflecting their views this way might even end up holding the market portfolio in aggregate (cancelling out each others’ ex-this and ex-that). So the net market impact is zero (or at least reduced).

    This line of thinking assumes manipulating share prices might impact the targeted firms’ behaviors (or existence). However, the point of my article is that the transmission mechanism whereby these views are expressed via allocating or dis-allocating investment dollars is flawed anyway. Either way, it calls into the question the efficacy of these strategies.

  • Digitking

    Sorry for not being clear, I’m trying to say that there’s always going to be someone (or group) that objects to any given company, industry or sector. So it becomes a slippery slope (especially for investment managers of public assets), because if they start to effectively following the demands of one interest group (say environmentalist) then wouldn’t they have to do the same for all other interest groups.

    Take the public pension plans, if they cave to environmentalist demands to dump energy companies. What do they tell the unions or labour groups that demand they dump their consumer staples or discretionary holdings that they object to?

  • I see, thanks. That is a good point re: public managers. To me, this is just one more reason to invest for returns and tackle social and other issues separately.

  • Toomush_Inferesistance

    The real reason corporations are not people is that they have only one inherent moral intention: to make increased capital for their major stakeholders. In contrast, non-profit corporations have several ethical goals: to provide charitable activities or outcomes for their constituents, for example (501c3s). If I were the king of the jungle, I would require a similar second mandate to for-profit corporations in order for them to continue to do business, something along the lines of “do no harm” or make the world a better place”. This wouldn’t insure anything, but it would give a legal response to corporations that are unduly harming the environment or driving populations into starvation.

  • Thank you for your comment. I agree corporate mandates do not necessarily align with the broader themes around social/environmental/etc issue. So I think your point is more or less in line with Nick’s comment regarding a “legislative fix”. In my mind, we already have something like this in the form of regulatory bodies – though I am not saying they are working as well as they could.

  • Jacob Rothman

    The article assumes that the point of SRI is to punish management and owners for participating in activities the investor in question disapproves of. Following that logic, the argument is quite clever. On the other hand, there are other goals that may be held by the SRI investor. One may be to not own businesses one deems to be objectionable. To take an extreme (and hypothetical) example, if there was a publicly traded company that engaged in human trafficking, I would avoid it, even if my actions made no difference in the scope of its operations. I just would not want to be in the business of human trafficking, even as a passive owner. Second, if the SRI investor were interested in a reduction of the operations rather than punishing existing holders and management, avoiding securities of objectionable companies would be effective if done by enough capital. A very low stock price could lead to higher prospective returns for the shareholders, but this would be at the expense of growing or sustaining the business as funds that would be reinvested if the cost of capital were lower are now better used to buy back shares.

  • Agree completely. SRI investors have various incentives — no doubt! The discussion here was related to those who leverage SRI as a tool to affect corporate policy. Your point about cost of capital is a good one that I brought up as well with Aaron. He has a comment on this concept in the post, but I’ll leave it to him to address in more detail.

  • Thank you for your comment. Your (extreme) example highlights the issue well. Perhaps a better question is to ask: Would you invest in it if you knew your investment actually negatively impacted the fundamentals and thus long-term performance? How about if it provided stellar returns you could use to campaign against its (or other undesirable) practices? I realize this is hypothetical, but I trust you see my point.

    Regarding your second point: I think the existence of price-sensitive (value seeking) non-SRI investors (I’m thinking hedge funds) would not allow these strategies to be so effective. Either way, it is not necessarily an either/or decision (capital investment vs buybacks). Firms can borrow money and take advantage of both opportunities.

    At very least, I think the logic is not as straightforward as many have directly or indirectly claimed. I suspect many investors believe they are doing more good than they actually are via these strategies.

  • Sam Zaydel

    It seems to me that one aspect of this has thus far been missed. Credit is a part of most businesses, good or bad, whatever your definition of good or bad is. Often a very critical part indeed. I did not see a mention of this here, and am wondering whether SRI has positive effect on credit ratings of companies who are seen as socially or otherwise responsible businesses, as well as whether there are any tangible negative long-term credit effects on less socially conscious businesses.

  • Thanks for your comment Sam. I have not seen anything relating to the impact of SRI (and the like) on the credit side. My suspicion is that ratings agencies and banks will not favor these businesses from a credit perspective unless there is (1) a tangible fundamental benefit or (2) a subsidy of some sort (whether from public or private entities). Having said that, my article’s logic still applies to debt repurchases. In fact, I recall research indicating debt buybacks have been used to manage (manufacture) earnings.

  • Sam Zaydel

    Aaron, thanks for replying. And, makes sense, great response! I think I agree about being less favored. It seems like it may be seen as a fad (though everything seems to be a fad in some ways), and perhaps could be viewed as something that can easily fall out of favor with investors, which may lead to prolonged periods of stock underperformance and possibly affect performance of the organization against its competition.

    This makes me wonder if there is really a way to make SRI/ESG sustainable and durable. Perhaps we are just overthinking about this. I think conventionally competition does not bring out the best, so maybe the two are just too opposed to each other for SRI/ESG to meaningfully take hold and sustain.

  • Other than trying to figure out the capital needs of companies and buying/avoiding accordingly (as outlined in my article), I just do not see an effective way to pursue such goals with investment dollars. Even then, there is just no guarantee it will work (impact corporate behavior). Moreover, these strategies typically cost more to execute and likely (in my view) impose a drag on returns.

  • Sam Zaydel

    Hopefully we can still promote SRI-leaning behavior as consumers and impact companies with our product or service buying decisions. Information is both enemy and friend. We are more informed than ever as consumers, and are becoming better informed by the day. It is not unreasonable to think that maybe consumer choice, awareness and consumers’ own commitment to improving the world around them in some ways will be enough to more directly impact the companies and promote operations that end-up improving the world around us.

  • Agreed. The consumer approach certainly has a more direct impact.

  • Sam Zaydel

    I will continue to do my part! 🙂