Juggling social and financial returns

This is one of a series of columns that were produced for Moneyweb Investor in which Stuart Theobald explores the intersection of philosophy of science and finance. This followed an earlier series for Business Day Investors Monthly on the same theme. This column was first published in March 2017. 

Is doing good profitable? Are companies that prioritise having a positive social impact also ones that make the biggest returns for investors? It would be very comforting if the answer was “yes”. It would mean that the decision over what to invest in can be made both by thinking about which companies are good for society and which companies are good for their financial returns. We wouldn’t have to choose one or the other. Unfortunately, it’s not that easy.

There are many technical developments that have supported investors in accessing socially responsible investments (SRIs). The JSE operates a “Responsible Investment Index Series” with Top 30 and general indices that include companies that meet the JSE’s responsible investment “ground rules”. They were introduced in 2015 to replace the JSE’s previous SRI index that used a different methodology. The exchange-traded fund market has also various options that allow investors to choose investments that meet certain social objectives, such as Absa Capital’s “NewSA” ETF or Grindrod’s CoreShares “Green” ETF. Oddly, there is not currently an ETF based on the JSE’s responsible investment index. Perhaps that is because support for the ETFs have been minimal, with the NewSA commanding assets of R36.7m and the Green ETF R45.7m. To put that into context, the Satrix 40 ETF has assets of R6.7bn.

There is no doubt, however, that social investing is a growing trend. According to a US-based study, socially responsible investments now account for 20% of global capital markets, with $30-trillion of assets based on SRI principles. A lot depends, however, on how SRIs are determined. I imagined that the important issues are sustainability, so wouldn’t expect mining companies among constituents, or avoiding socially harmful products, so wouldn’t expect cigarette companies. Yet in the JSE’s SRI Top 30, you’ll find both Anglo American, together with its platinum and iron ore subsidiaries, and British American Tobacco. The index is assembled by FTSE Russell, created by rating companies on environmental, social and governance measures (ESG), ranging from support for biodiversity and respect for human rights, to anti-corruption procedures. A company which does little for the health of its customers, can score on various other measures such that it makes the grade. It should be clear, however, that when comparing SRI-based investments to non-SRI investments, there might not actually be much difference beyond the application of the label “SRI”.

The argument that social returns and financial returns are congruent usually works by claiming that socially responsible companies have better relationships with their stakeholders. As a result, customers are more loyal, staff more content, and regulators and politicians more conducive to supporting a positive environment in which that company can profit. They are also more sustainable, so don’t exhaust the resources necessary to maintain profitability. Such arguments put profitability as the prime objective, essentially claiming that social responsibility is good because it’s profitable, and not because it is good in its own right.

The evidence is ambiguous. There have been many studies globally that compare SRI funds with general funds, usually finding that there hasn’t been much difference (though there are exceptions which have found SRIs outperform). This is largely because there’s not actually much difference in the underlying companies held in SRI and non-SRI portfolios. One study[1] applied a higher bar to see what would happen to performance. It considered three different ESG ratings providers (not FTSE Russell used by the JSE, but similar) and portfolios of high rated companies with low rated ones in the US. So this eliminates the overlap between ESG and non-ESG, effectively dividing the universe into two separate halves (or smaller fractions by pushing up the cut off for the high group, and down the cut-off for the low group). Even then, the study found that there was no material difference between the high and low rated portfolios, and that it would be impossible to create a sustainably outperforming investment strategy as a result. This did differ depending on the particular ESG rating system that was used, however, so there may be an argument that ESG outperforms, provided only that the right ESG measure is used. This ambiguity can be seen in the JSE’s indices too – the old SRI index underperformed the Top 40 index in the three years to the switch in 2015, since when the new SRI index has slightly outperformed.

The impact on profitability of ESG factors is at least partly a function of policy. If governments introduce carbon taxes, for example, carbon intensive industries are going to become less profitable. So the performance of high-ESG scoring companies may be the result of administrative fiat rather than normal market forces. This works the other way around too – promises by president Donald Trump that he will slash environmental and other regulations on American business have caused a share price rally, as lower ESG-scoring companies look set to benefit.

Even if we accept that SRI investments don’t consistently outperform non-SRI investments, it also follows that they don’t underperform them. If we accept that investing is not only about profit, the lesson we can take away from that is that SRI investing does not come at a cost. That is still true when more stringent ESG criteria are applied. That alone suggests SRI investing is at least as good as non-SRI investing, and probably better for other reasons.

However, even on future profitability, it seems hard to resist that as climate change forces environmental concerns up the agenda, and the growing middle class in emerging markets demand increased health interventions, policy is going to systematically favour higher ESG scoring companies. Trump may be a very short term bump in the road toward that outcome. SRI investing comes at no cost, and is effectively an option on the upside that regulation may induce. The trick, however, will be to figure out just which companies are going to thrive in such an environment, and standard SRI measures may well fail to capture it. There may be no short cut other than examining companies case by case and exercising judgement about their sustainability in an environment of ever-strengthening ESG regulation.

[1] Gerhard Halbritter and Gregor Dorfleitner. 2015. The wages of social responsibility — where are they? A critical review of ESG investing. Review of Financial Economics. Volume 26, September 2015, Pages 25–35.