Back in 2015, Georgetown University joined several other large endowments in announcing that it would divest in coal-related investments due to the potential environmental impact of burning coal in powerplants1. The university’s decision is an example of socially responsible investing (SRI), where an investor will not consider owning the stock of a company that conflicts with an ideology.
“Ethical” investing has exploded both in size and scope. What began as avoiding “sin stocks” (companies that sell tobacco, alcohol, firearms, etc.) in a portfolio has now grown to include the consideration of firms’ environmental, social and governance (ESG) performance.
Wall Street has responded by creating hundreds of mutual funds and Exchange Traded Funds (ETFs) that cover everything from clean energy to companies that score high on gender diversity in the workplace. There are even services that will rank funds based on ESG metrics2. On the other end of the political spectrum, funds that target conservative values and beliefs are also growing rapidly3.
Despite the growing popularity, let’s discuss five issues that investors should recognize before they get too political with their investments. The first is diversification, which is the “Golden Rule” of investing. Confining stock selection to only those that meet ideological guidelines can leave a portfolio exposed to avoidable risks. For example, sin stocks tend to hold up better during recessions, which could potentially smooth out the ride over time.
Second, sin stocks tend to be cheaper on a valuation basis because so many large money managers are restricted from owning them. This discount can often reduce the risk of ownership relative to stocks with higher valuations.
Third, owning stock in a company has little to no effect on its revenue generation, earnings, and cash flow. The irony behind these endowments’ decisions is that making a difference in a company through activism generally works way better by owning more, not less, of a company’s stock. Meaning, if the endowments really wanted to impact the coal industry, they should have bought all the coal stocks they could find to the point where they could get in the boardroom of coal companies and enact real change.
Fourth, implementation is virtually impossible. Endowments no longer own coal stocks, but they likely still own stocks of companies that pay coal plants for power. Furthermore, they almost certainly own stocks of companies that make products using coal-based power. Similarly, conservative funds likely own stocks of companies that buy from Big Tech.
Fifth, numerous studies conclude that screening out sin and other vice stocks reduces risk-adjusted returns over time4. Many of these ESG and conservative funds also charge higher fees, so investors may end up paying more for less over time.
Add it all up and the data indicate that there could be a financial price to pay for getting political with investments.
The Bottom Line
The tobacco industry sells a highly addictive product that kills thousands every year. The pain and suffering that this industry has caused the world cannot be quantified, and it’s tough to find many people out there who would come out and defend the practices of Big Tobacco.
However, despite the efforts of the government, health insurers, and media campaigns designed to help people quit, tobacco stocks have crushed the S&P 500 over the last ten years5. Why?
Because their product is mostly recession-proof (smokers smoke in good times and bad), their management teams don’t start price wars (keeping margins high), and they generate piles of cash (fueling attractive dividends). As a consumer and someone who utterly despises the smell of cigarettes, I find the product to be less than appealing. But as an investor, these characteristics are very attractive.
If I were to inject my emotional views on tobacco into my portfolio and refuse to own these stocks at any time, it may make it a lot harder for me to meet my financial goals. Making matters worse, it would have zero effect on the demand for cigarettes. It could end up being a lose-lose situation.
Don’t view this as an endorsement to turn a blind eye to personal convictions for the sole purpose of profit. Quite the opposite. Keep your beliefs but channel them in a far more effective way. Here is how to do it.
First, remove all emotion from your portfolio and maintain a strict focus on picking investments that have the potential to deliver attractive returns and improve diversification. Then, if a gain is realized on an investment that conflicts with a belief, take those proceeds and donate them to a charity that you support. Not only will you be making a more powerful impact, you may qualify for a tax deduction.
The bottom line is that while SRI and conservative strategies may sound appealing, placing emotional handcuffs on an investment process may pose material risk to long-term financial goals while doing little good for the cause being supported.
Sources
2 https://etfdb.com/etfs/investment-style/socially-responsible
3 https://www.wsj.com/articles/trump-allies-promote-portfolios-targeting-unwoke-investors-11621342803
4 https://www.etf.com/sections/index-investor-corner/swedroe-costs-socially-responsible-investing
5 Bloomberg
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal, investment, or accounting advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.