One of the most important tasks of a modern industrial society is the allocation of capital. It is absolutely essential that in a democratic milieu capital assets be allocated to benefit the majority of productive individuals. William J. Baumol, a leading political economist of the 1960s, has noted the following:
The allocation of its capital resources is among the most important decisions which must be made by an economy. In the long-run an appropriate allocation of real capital is absolutely indispensable to the implementation of consumer sovereignty (or of the more appropriate concept—public sovereignty—which takes into account all of the relevant desires of the individuals who constitute the economy).[1]
This article addresses the central question of public sovereignty of the capital markets wherein the public, and not bankers, decide the allocation. Is the current methodology of capital allocation taking into account all of the relevant desires of the public who constitute the economy? The debate centers on socially responsible investing (SRI). What is more important, morality or profitability, and are they mutually exclusive? Do corporations have a responsibility to the environment, to their employees, to the communities in which they reside that supersede the corporations’ responsibilities to investors? On the other hand, do investors have the responsibility of focusing on companies that have great socially responsible track records over corporations that fail on these records while seeking dividends and price appreciation?
While capitalistic markets are disproportionately focused on “profit at all cost,” few trends would so thoroughly “…undermine the very foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as they possibly can,” said the late Milton Friedman.[2] Likewise the late George J. Stigler noted the importance of capital markets’ regulation of behavior.[3] Both of these economists are Noble Prize recipients as well as coming from the Chicago School of Economic Thought giving even more substance to their comments. This latter comment remains as important today as when Stigler made the statement. Secretary of the Treasury Paulson on November 20, 2006 called for the U.S. to “rethink” governance rules to keep the U.S. capital markets competitive.
If we believe that American public sovereignty of the capital markets include ethical behavior with equal financial results, it is obvious that we are in serious denial with some radical change in business behavior required. Otherwise, we end up just like any other third world country.
Shareholder Wealth
More often than not, corporations today are expected to utilize the shareholder wealth model, developed in the 1950s, stated in terms of maximizing shareholder wealth. In general, such a model demands a large earnings per share (EPS) growth rate without any social considerations. Historically, this has not been the case. Corporations were at one time essentially privately owned as well as local in character. Consumers more or less assumed that the entrepreneur’s own morality was incorporated into the firm. If a corporation behaved poorly by a community’s standards, this firm often would be boycotted especially if a substitutable product or service existed. We still see a modest amount of boycotting, but it is almost solely confined to small businesses with consumer sales. It is perhaps unfortunate that one cannot invest in many of these small businesses and their potentially higher community standards.
This provincial approach all but disappeared with the rise of the modern public corporation by the 1920s. This divorce of ownership from control resulted in a new form of economic behavior as so clearly noted by Berle and Means in 1932.[4] In the opinion of many, one aspect today of this separation of ownership from control is excessive pay to executives, predominately through stock options, which encourages dominance of the EPS growth aspect at all costs. This obsession with wealth has further caused a major ethical issue of backdating of options, which appears to have become widespread among American corporations. The theft of stockholders’ funds in recent times appears to run into billions of dollars.
The magnitude of the ethical problem for American corporations can be noted by the statement from Transparency International (TI), the anti-corruption watchdog, While TI concentrates predominately on international business transactions and the corruption of governments, it is not solely derived from this perspective. Thus, on Monday, November 6, 2006, TI reported that “the U.S. has suffered a ‘significant worsening’ in the perceived levels of corruption.”[5] The U.S. fell from a ranking of the 17th least corrupt nation to 20th among the 163 nations reviewed by the Berlin-based organization with a score of 7.3. This score equaled those of Chile and Belgium. Indeed, it should be noted that both Singapore and Hong Kong are ahead of the U.S. on this critical issue. One concluding comment from The Financial Times stated that “For companies, thinking just in terms of compliance is not enough.”[6]
When corporations make heinous decisions in an attempt to attain a high EPS growth rate (such as Ford’s decision to produce the Pinto in the face of overwhelming evidence that the vehicle was unsafe), the government steps in to administer punishment. Such decisions become more opaque, however, when the ethical/moral issues are less explicit and difficult to quantify. A case in point is the mining industry. Although mining is necessary to gather production resources for a modern industrial economy, it also often damages the environment. Is it wrong to prospect for sources at the expense of the natural environment?
Through their demand for equity, investors can dictate what is most valued in world opinion. For example, if companies whose pollutants damage the environment see their stock prices plummet, the cost to such companies of converting to a more environmentally conscious operation would no doubt be offset by positive price appreciation in their stock accompanied by a reduction in their cost of capital.
Socially Responsible Investing (SRI)
In a capitalistic marketplace, the stockholders hold the “ultimate authority” over corporate conduct. Unfortunately, it is a “passive” ultimate authority. Due to the U.S. Securities and Exchange Commission’s unwavering support of corporate management in proxy matters (in the opinion of the authors), the only “ultimate authority” is the passive strategy of selling the underlying interest rather than trying to change the behavior of management. Another, more pro-active strategy would be to limit investments to companies meeting reasonable criteria for the concept of a Socially Responsible Investment (SRI). Yet another, even more pro-active strategy, is to have the SEC or Congress change the proxy rules. This may happen due to recent Federal court decisions questioning the SEC’s position on shareholders’ proxy rights and the difficulty of placing issues before shareholders at the annual meeting.
Socially responsible investments “to a large degree depends on the investor.”[7] While some estimate that the market for socially responsible investment (SRI) funds stands at $2.16 trillion,[8] the actual criteria used to define SRI are rather subjective. The Social Investment Forum lists 12 types of screens for company exclusion. These screens include the following industries or issues: alcohol, tobacco, gambling, defense/weapons, animal testing, product/service quality, environment, human rights, labor relations, employment equality, community investment, and community relations. Many believe that other screens need to be added such as ethical management. Needless to say, there will be no end to the debate dealing with the proper selection of screens for SRI.
Value Based Leadership (VBL)
Many individuals can reasonably disagree over some of these screens. Many individuals also believe that other screens need to be added. One of the most commonly suggested is Value Based Leadership (VBL). For example, companies found engaging in unlawful or immoral conduct, such as backdating options, should be rejected as an investment candidate until the guilty company is rehabilitated. In fact, the potential screening list can almost reach the point at which all companies must be eliminated. Hence, there is a real need to develop a consensus regarding the VBL definition. In fact, there is a real need for a consensus selection of companies that would become part of an SRI Index. Investment managers today basically develop their SRI qualified companies through internal analysis.
Finally, there is the problem of selective screening. Certain mutual funds also select companies based on other criteria. For example, the Aquinas SRI mutual funds invest in only those companies that reflect core Catholic religious values, while the Sierra Club mutual funds invest in only those firms that have positive environmental track records.
The securities markets are comprised of companies having vastly different moral and ethical track records. The concept being suggested here is the recognition of the Value Based Investor (VBI). If Value Based Investors exercised their financial power by encouraging social responsibility among corporations, then a large sum of investment dollars would flow from socially responsible investors, and a goodly number of mutual funds, investment companies, state retirement boards, and investment advisors would utilize screening techniques to isolate companies having high degrees of social and moral responsibility.
Amy Domini notes, “The way you invest can contribute not only to your bottom line but also to a just and fair society.”[9] Yet, overwhelmingly, mutual funds do not utilize any qualitative SRI screening techniques. Perhaps the multiple qualitative criteria make the concept difficult to market? Karin Grablin, a financial planner with Dictor Martin Investments, has stated that “…most clients are pretty much looking for performance, and they’re probably more geared towards that angle than social responsibility.”[10] Investment management firms that manage client assets and/or manage mutual funds for investors have a responsibility to their investors to maximize returns. Without returns, such firms lose clients. Their choices are as much about their clients’ well-being as they are about self-preservation.
Why do the majority of firms seem apathetic towards SRI strategies? It has been strongly suggested that such strategies are simply less profitable than non-SRI strategies. Then the ethical question also becomes, “What is more important—social responsibility or overall profitability?” We know that the Adam Smith “invisible hand” (individuals collectively will undertake the best economic choice) is not always correct from a moral position. Is the return differential between SRI strategies and non-SRI strategies minimal, or does the alpha (or excess return not accounted for in its beta, a measurement of risk) of non-SRI investments compensate society for the negative societal externalities produced by corporations that do not act socially responsible?
Modern Portfolio Theory (MPT)
Two contradictory schools of thought exist about how to construct a portfolio of equities to maximize shareholder return. Modern Portfolio Theory (MPT) suggests that SRI investments are inferior to non-SRI investments. As per MPT, there are two categories of risk in the marketplace: systematic, associated with the overall markets, and unsystematic, or specific risk associated with a specific sector, industry, or business.
Diversification is the process by which investors add additional non-perfectly correlated securities in such a manner that Security A can partially mitigate the unsystematic risk of Security B within a portfolio. Efficient capital markets reward investors for systematic risk, which cannot be diversified away, but do not reward unsystematic risk, which is easily diversified away in an efficient portfolio through the addition of non-perfectly correlated securities.[11]
While all this sounds complex, it is not. Every stock and industry has a different business risk. MPT suggests that you take one stock from one industry (like an oil stock) and combine it with another stock with a different business risk profile (like a plastic manufacturer). The stocks move in less than perfect tandem (non-perfectly correlated.) In pragmatic terms, an investor should have no fewer than fifteen stocks in their portfolio with no more than two stocks from any one industry. This will result in a good degree of diversification being achieved.
Investors who choose to limit available securities using qualitative, non-financial criteria limit their ability to achieve adequate diversification. Using our example above, an investor might be forced to use three stocks instead of two from a particular industry. This portfolio like SRI funds will then bear a substantial amount of specific risk versus non-SRI funds and should logically achieve lower risk adjusted returns. In addition, firms that choose to invest capital in costly social programs increase costs and operate less efficiently than do firms that do not. Therefore, not only do SRI funds limit their investment universe at the expense of adequate diversification, but they may also be selecting from a pool of inferior companies that have uncompetitive cost structures.
Stakeholder Theory
Modern Portfolio Theory and simple portfolio construction accurately describe the diversification inefficiency that SRI strategies bear, but do not offer any explanation of possible benefits that socially responsible policies create. In support of SRI investments, the other school of thought is Stakeholder Theory. “Stakeholder Theory….portrays managers as individuals who pay simultaneous attention to legitimate interests of all appropriate stakeholders, both in the establishment of organizational structures and general policies and in case-by-case decision making.”[12]
In Modern Portfolio Theory, all stocks are considered homogenous. Stakeholder Theory suggests that a firm’s management of internal and external relationships will have significant positive or negative effects on future profitability. For example, a social agenda that includes above-market benefits for employees will attract the best workers, thereby making that company’s human capital more productive. Positive interactions with the communities surrounding plants/offices will result in more favorable negotiating power with local government officials for profitable tax breaks and other contractual obligations. Positive goodwill from superior social agendas will result in long-run economic and financial success. While the pool of possible investments is limited by using subjective criteria, Stakeholder Theory suggests that the available pool contains superior investments. As investors randomly select companies from a smaller pool of possibilities, the higher quality of those companies in the smaller sample offsets any negative effects described by MPT.
Eugene Ellmen, executive director of the Toronto-based Social Investment Organization (a non-profit trade association encouraging SRI strategies located at www.socialinvest.org) says: “Some people have the impression that to invest responsibly, you have to sacrifice returns…it’s a misconception to say that SRI investing leads to underperformance.”[13] Unfortunately, there have been many studies that have questioned this statement.
A recent paper by Michael Barnett and Robert Salomon has generated signal interest about SRI performance. Their very insightful paper also sought to distinguish between various SRI criteria, identifying the effects of the various SRI screens. Barnett and Salomon tested all 12 of the accepted screening methods (noted above) for SRI funds, but specifically targeted the effects of singling out firms due to environmental policies, labor policies, and community relations.[14]
The study resulted in several interesting conclusions. One such conclusion states, “The relationship between the intensity of social screening and financial performance for SRI funds is curvilinear or U shaped.”[15]
- Mutual funds that use all 12 criteria are nearly as successful as funds that use none. However, mutual funds that use a handful of criteria, or that periodically relaxed their assumptions around social responsibility, suffer.
- Mutual funds that stick to their core values and use all 12 of the accepted social responsibility screens apparently are able to realize on a broader scale enough long-term value through positive relationship building as to offset any negative results from lacking diversification.
- Mutual funds that relax their criteria and show a lack of discipline towards those core values only end up bearing the negative externalities of less diversification; those companies do not realize sufficient positive value from their socially responsible criteria.
It would thus appear that SRI investing is an “all or none” proposition. This also mitigates the fact that particular SRI screens work at different times. In portfolio management, growth at times does better than value, or the reverse, and many other examples are possible.
Barnett and Salomon found a statistically significant—though small—positive relationship between positive community relations and financial performance. Michael Barnett reports, “Funds that select investments for their portfolio based on community relations screening criteria will earn higher financial returns than those that don’t.”[16] However, the study also showed that positive environmental track record and positive labor relations screening resulted in statistically significant negative effect on returns.
The Calvert Mutual Fund (CMF) organization is one of the better known SRI groups with a long-term record. It is useful to compare their performance against an SRI benchmark, albeit one they created themselves. The Calvert Social Index today contains approximately 600 large capitalized companies. The index is constructed by taking the top 1000 companies by capitalization and then analyzing each company according to SRI attributes. It is from this population that Calvert develops its portfolio selections. The performance of these funds is indicative of the gap differential in constructing SRI portfolios against the market. The performance results of selected funds are as follows for the period ended January 31, 2007 as reflected on the calvert.com website.
| Fund or Benchmarks | One Year | Three Year | Five Year |
|---|---|---|---|
| Calvert Social Index | 11.93% | 8.05% | 5.25% |
| Calvert Fund Equity/No load | 11.06% | 7.23% | 4.43% |
| Calvert Fund Equity/Load | 5.79% | 5.51% | 3.42% |
| Lipper Multi-Cap. Core | 12.45% | 11.49% | 6.31% |
| S&P 500 Index | 14.51% | 10.32% | 6.82% |
Average Annual Returns (%) For Period Ending 1/31/2007
http://www.calvert.com/funds_performance.html. (no longer accessible).
It is clearly disappointing that the Calvert Social Index (a non-managed fund) underperforms its noted benchmark (Lipper Multi-Cap. Core) in all three periods as well as underperforms the S&P 500 Index (total return) in the same three periods. Likewise, it is disappointing that the other two Calvert funds (managed funds selecting stocks within the index) underperformed as well.
SRI investment returns face a return challenge that must be clearly noted. Recognizing the limited testing period and population, socially responsible investing does appear to provide less than optimal investment performance. It appears that investors are not signally sacrificing their investment performance if they use very stringent social responsibility criteria. The fact that SRI mutual funds involved in the Barnett and Salomon study have higher expense ratios on average than do non-SRI investments[17] could account for the difference. Those higher expense ratios could be the result of lower operating efficiency of smaller firms that operate in the SRI marketplace rather than the difficulty of managing the portfolios. Regardless, the negative relationship is in no way significant enough to dismiss the societal benefit of the socially responsible stock selection. Rather, it raises the question of why more investors are not allocating funds to SRI investments.
One of the original questions in this article is whether or not social responsibility or investment returns has the greater value. For the individual investor, SRI investments utilizing currently existing SRI mutual funds will on average under-perform non-SRI mutual funds, encouraging investors to avoid them. However, since much of the underperformance appears to be a result of transaction costs and fund management expenses associated with small funds, there remains hope if more investors demand such types of SRI as part of their overall portfolio construction. This orientation could alter corporate decision making by increasing the demand for stocks of corporations having social priorities and policies deemed by society to be ethical.
According to Karl Marx, history is economics in action. If investors demand an SRI orientation, then it will follow. It becomes clearly essential that Value Based Investors insist on investing in Value Based Leadership Companies. This could promote positive initiatives for ethical conduct in workplace relations, production, and the environment.
This article also creates a challenge for pragmatic portfolio managers. The Calvert (or like) Social Index does contain a significant population. Are there not portfolio managing techniques available to construct within the social index a sub-set of companies that can not only outperform the index itself, but can outperform the Lipper benchmark as well? If so, there would be far less reticence by investors to own such SRI portfolios.
[1] William J. Baumol, The Stock Market and Economic Efficiency (New York: Fordham University Press, 1969), 1-2.
[2] Linda S. Munilla, “Corporate Social Responsibility Continuum as a Component of Stakeholder Theory,” Business and Society Review, 110, no. 4 (2005): 371-387.
[3] George J. Stigler, “Public Regulation of the Stock Market,” The Journal of Business, April (1964): 117.
[4] Adolf A. Berle, and Gardner C. Means, The Modern Corporation and Private Property. (New York: Macmillan Company, 1932).
[5] Hugh Williamson, “U.S. Seen as Getting More Corrupt, Says Watchdog,” The Financial Times, November 7, 2006.
[6] Ibid.
[7] Brian Neill, “For Some, Conscience Leads the Way“, Bradenton Herald (Bradenton, FL), October 3, 2006.
[8] “Socially Responsible Investing Trends in the United States,” Social Investment Forum, (1999).
[9] Domini, Amy L. Socially Responsible Investing: Making a Difference and Making Money (Chicago: Dearborn Trade, 2001).
[10] Brian Neill.
[11] Michael L. Barnett. “Beyond Dichotomy: The Curvilinear Relationship Between Social Responsibility & Financial Performance,” Strategic Management Journal 27, March (2006): 1101-1122.
[12] T. Donaldson and L. E. Preston, “The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications,” Academy of Management Review 20, no. 1 (1995): 65-91.
[13] Paul Brent, “Ethical Funds Gain Popularity,” Toronto Star, October 12, 2006.
[14] Michael L. Barnett.
[15] Ibid.
[16] Ibid.
[17] Samuel R William, “Fund Spy“, Morningstar Column, September 5, 2006.
