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Socially Responsible Investing: Expect Lower Returns

A reader writes in, asking:

“Do you have any suggestions for people who want to invest in environmentally friendly companies? Are there any good mutual funds that do that? Or is it better to research companies/stocks one by one?”

If you really want to be careful about which companies you invest in, researching companies one-by-one certainly gives you the most control. The downside, of course, is that doing so takes a lot of time and leads to a far less diversified portfolio than you could have by using something like a “total stock market” index fund.

If you’re willing to give up some control, you could consider Vanguard’s FTSE Social Index Fund. The fund tracks the FTSE4Good US Select Index, which screens companies based on an assortment of social issues, including environmental ones. The fund owns 340 stocks, which is a heck of a lot more than a person could handle via individual stock picks.

That said, using such a fund for the stock portion of your portfolio certainly has its drawbacks:

  1. With 340 stocks, it’s meaningfully less diversified than a portfolio including both a “total U.S.” index fund and a “total international” index fund, which means you’d be taking on more risk for a given level of expected return, and
  2. Its 0.29% expense ratio is slightly more expensive than non-socially-responsible index funds. (It is, however, far less expensive than most socially responsible mutual funds.)

Lower Returns is the Goal

In addition, it’s worth noting that, if the goal of socially responsible investing is to drive cost of capital down for socially responsible companies, that’s the same thing as driving investment returns down for investors in socially responsible companies.

This is easier to understand if we think for a minute about bonds rather than stocks. Consider a socially responsible company (whatever that means to you) that is planning to expand, but which needs to raise capital to do so. The company decides to raise capital by issuing bonds. As a socially responsible investor, you like the idea of lending money to this company by buying its bonds. And your hope is that other socially responsible investors would make the same decision, thereby significantly increasing demand for the company’s bonds and allowing the company to get access to capital at a lower interest rate.

Well, that lower interest rate is not only a lower cost of capital for the company, it’s also a lower rate of return for people who buy the bonds.

And an analogous thing happens with stocks. If socially responsible investors are numerous/wealthy enough to succeed in materially increasing the demand for socially responsible stocks, investors will have to pay more for each dollar of socially responsible corporate earnings than for each dollar of socially irresponsible corporate earnings.

In other words, by attempting to help out socially responsible companies by giving them lower cost access to capital, you are intentionally seeking lower returns. Of course, depending on your goals, that might be a tradeoff you’re happy with.

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Comments

  1. Joe Reeves says

    I haven’t heard this argument for socially responsible investing before. Where did the idea of lowering the cost of capital for these companies being the impetus, as opposed to everyone I’ve ever known who was interested in socially responsible investing simply not wanting to invest in various industries (defense, tobacco, etc,) and companies (Altria, Raytheon, etc,) or hoping their money was going to help those companies that weren’t doing obviously detrimental things in the world

  2. Joe,

    When I get questions from readers about socially responsible investing, they tend to be framed in terms of wanting to help companies they approve of (and/or not wanting to help companies they don’t approve of).

    But I have no evidence other than my personal experience. In other words, it’s just anecdotal, and you may be quite right that most people’s motivations are different from what I’ve seen.

  3. Mike,
    Perhaps one thing you could do to clarify this post is to more explicitly state your benchmark against which you conclude social investors are earning lower returns.

    When most people discuss ‘lower returns’ they are referring to lower compared to the investable universe, for example some index.

    In your example, you are comparing ‘lower returns’ to some counterfactual cost of capital the company would have had had no social investor invested in them.

    You also would need to show that companies that have lower costs of capital are inferior investments. Needless to say this is a somewhat startling claim, as low cost companies are broadly empirically shown to have a competitive advantage in the market place, all else equal.

    Any individual fund, including Socially Responsible funds, may or may not be attractive investments. However, the question of investment performance has been studied and researched many different ways and a high level of confidence can be placed on the ex-ante view that whether a fund is Socially screened or not will not predict future performance.

  4. Dan,

    I think you misunderstood. I apologize for the lack of clarity.

    I wrote, “In addition, it’s worth noting that, if the goal of socially responsible investing is to drive cost of capital down for socially responsible companies, that’s the same thing as driving investment returns down for investors in socially responsible companies.”

    I am not arguing here that socially responsible stocks earn lower returns. I am arguing that reducing their returns is the goal of socially responsible investors.

    As far as the increased costs on most socially responsible funds though (relative to low-cost index funds), I think that’s as good a predictor as it ever is, which is to say it’s helpful (and better than most predictors) but not at all perfect.

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