Sustainable Momentum Investing: Doing Well By Doing Good

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Includes: AMANX, AMINX, DRTCX, DRTHX, DSI, KLD, PARNX, VBMFX, VFINX
by: Gary Antonacci

Socially Responsible Investing (SRI), also known as sustainable or responsible investing, is the application of ethical as well as financial considerations in making investment decisions. SRI therefore recognizes and incorporates societal needs and benefits.

History of SRI

SRI may first date back to the Quakers who, in their 1758 yearly meeting, prohibited members from participating in the slave trade. Their Friends Fiduciary investment service has existed since 1892 and continues to manage Quaker assets following SRI guidelines.

Another early adopter of SRI was John Wesley (1703-1791), one of the founders of the Methodist Church. Wesley's sermon on "The Use of Money" outlined the basic tenets of social investing - do not harm others through your business practices and avoid industries which can harm the health of others. In the 1920s, the Methodist Church of Great Britain invested in the UK stock market while avoiding companies involved with alcohol and gambling.

The first public offering of a socially-screened investment fund was in 1928 when an ecclesiastical group in Boston established the Pioneer Fund. In 1971, a Methodist group organized the PAX World Fund, which appealed to investors who wanted to be sure their profits were not from weapons production. Two years later, SRI went mainstream when Dreyfus, a major mutual fund marketer, launched the Third Century Fund, which grouped together companies noted for their sensitivity to the environment and to their local communities.

Social Change through SRI

In the 1980s, SRI became more widespread with its negative screening of investments in South Africa. SRI practitioners were able to put pervasive pressure on the South African business community. This eventually forced a group of businesses representing 75% of South African employers to draft a charter calling for the end of apartheid.

SRI Performance

Although SRI has helped bring about social change and has been emotionally rewarding to its users, there has been a long-standing question about whether SRI performance has suffered due to the restricted opportunities available to SRI investors. There have been many studies and meta-studies of SRI versus conventional investment past performance. One objective survey and assessment of the subject is the Royal Bank of Canada's 2012 report, "Does Socially Responsible Investing Hurt Investment Returns?" The conclusion they reached, based on all the available evidence, is that SRI investors have been no worse off than more conventional investors.

Evolution of SRI

SRI evolved from exclusionary screening out of investments to a more proactive approach toward Corporate Social Responsibility (CSR). CSR is a blend of negative screening and positive selection methods to maximize financial return within a socially aligned investment strategy. Examples of negative screening factors are involvements with gambling, alcohol, tobacco, weapons, under-age workers, animal testing, and damage to the environment. Examples of positive selection criteria are pollution control, community involvement, energy conservation, consumer protection, human rights, product safety, favorable employee working conditions, and renewable energy utilization. CSR oriented programs can also vote their proxies to advance ethical business practices, such as diversity, fair pay, and environmental protection.

CSR further evolved and expanded to include a broader set of Environmental, Social, and Governance (ESG) factors. Interestingly, these were soon found to be correlated with superior risk-adjusted investment returns. ESG was seen to have practical benefits for the companies that employ these criteria, as well as for investors in those companies.

There are number of reasons for improvements in performance because of ESG. Corporate responsibility can create good relationships with governments and communities, as well as reduce the risks of onerous regulations and conflicts with advocacy groups. It can also influence how consumers perceive a brand and therefore serve a similar role to advertising. This can lead to higher sales and more loyal customers. In addition, corporate responsibility can have a positive influence on companies' ability to attract and retain talented employees and maintain productive workforces.

Performance of SRI/CSR/ESG

According to DB Climate Change Advisors in their 2012 meta-analysis of more than 100 academic studies, "Sustainable Investing: Establishing Long-Term Values and Performance," 100% of studies showed that companies with high ESG ratings exhibited financial outperformance and had a lower cost of capital than more conventional companies, while 89% of highly-rated ESG companies exhibited market-based outperformance and superior risk-adjusted stock returns.

A typical study by Eccles et al. (2011) compared the performance of 180 large U.S. firms by matching 90 high sustainability firms with 90 low sustainability firms. Beginning in 1993, $1 invested in the high sustainability portfolio would have grown to $22.60 by 2010, while the low sustainability portfolio grew to only $15.40.

Rapidly Growing Investor Interest

Companies doing well now by doing good have not gone unnoticed by investors. The outperformance of high sustainability firms has been attracting considerable investor interest. According to a 2015 survey by the Morgan Stanley Institute for Sustainable Investing, over 70% of active individual investors describe themselves as interested in sustainable investing, and nearly 2 in 3 believe sustainable investing will become more prevalent over the next 5 years.

Looking at recent growth, the global sustainable market has risen from $13.1 trillion at the start of 2012 to $21.4 trillion at the start of 2014, and from 21.5% to 30.2% of all professionally managed assets. Europe has the highest percentage of sustainable assets at 63.7%. But the U.S. has been the fastest growing region over this period and now has 30.8% of all global sustainable assets. The amount of funds invested in the U.S. using social criteria grew from $40 billion in 1984 to $625 billion in 1991 and $1.5 trillion in 1999.

The most recent biennial "Report on U.S. Sustainable, Responsible, and Impact Investing Trends" by the Forum for Sustainable and Responsible Investing (US SIF Foundation) shows U.S. sustainable funds at $6.57 trillion in assets at the start of 2014, up from $3.74 trillion at the start of 2012. This is a growth of 76% in just two years. Assets held in some form of sustainable investment now account for more than $1 out of every $6 under professional management, up from $1 out of every $9 in 2012. Investors have realized that SRI funds, which in the past showed no disadvantage to conventional funds, have evolved into ESG funds that now offer superior performance to conventional funds.

Dual Momentum with ESG

In my book and on my website, I show how dual momentum can enhance the performance of many different kinds of investment portfolios, such as global equities, balanced stocks and bonds, equity sectors, and fixed income. I thought I would now turn my attention now toward using dual momentum to improve upon the risk-adjusted returns from sustainable investing.

I usually prefer to use low cost, index ETFs as investment vehicles. However, that may not be the best approach with sustainable funds. There are two reasons for this. First, the difference between index ETFs' and actively managed funds' annual expense ratios is not nearly as large for sustainable funds. For example, the annual expense ratios for the Vanguard and iShares S&P 500 ETFs are .05 and .07, respectively. The annual expense ratios of the two KLD 400 Social Index ETFs (NYSEARCA:DSI) (KLD), on the other hand, are much higher at .50. When you compare the sustainability ETFs with expense ratios of .50 to the S&P 500 ETFs with expense ratios of .05 or .07, the sustainability ETFs are at a decided disadvantage to their conventional counterparts.

The second reason that sustainability index funds can be problematic is their short performance records. The earliest U.S. based SRI index is the Domini 400 Social Index, which is now known as the MSCI KLD 400 Social Index. It did not begin until May 1990, and data for it is not readily available. The oldest SRI index fund (Vanguard FTSE Social Index (VTFSX) was established only 15 years ago in May 2000.[1]

For these reasons, as well as the reason that active management might add some value in an area like sustainability, where more informed choices might be better than the mechanical rules of an index, we will look to apply dual momentum to the oldest, actively managed, sustainable equities-based mutual funds.

Funds Used

The three sustainability equity mutual funds that have track records longer than 25 years are the Dreyfus Third Century Fund (MUTF:DRTHX) that began in April 1972, the Parnassus Fund (MUTF:PARNX) that started in May 1985, and the Amana Mutual Funds Trust Income Fund (MUTF:AMANX) that began in July 1986.[2]

Looking at these funds now, the only explicit exclusionary screen of Dreyfus Third Century is for tobacco products. However, Third Century has a strong ESG orientation by reason of their mandate to invest in companies that contribute to the enhancement of the quality of life in America, with special emphasis on the environment, product safety, employee safety, and equal opportunity employment. Third Century's annual expense ratio is 1.01, and the fund is closed now to new investors. However, the institutional class of shares (MUTF:DRTCX), with an expense ratio of .91, can still be purchased ($1,000 minimum) through some financial professionals and brokerage firms.

Parnassus Fund has an annual expense ratio of .86. This fund screens out companies involved with alcohol, tobacco, gambling, nuclear power, and weapons. Parnassus also engages in shareholder activism and community investment. The fund has a strong ESG orientation with its mandate to invest in companies having sustainable competitive advantages and ethical business practices. Parnassus also prefers to buy out-of-favor stocks.

Besides incorporating ESG factors and exclusions for alcohol, tobacco, and gambling, Amana avoids companies with high debt-to-equity ratios and large receivables compared to total assets. Their emphasis on companies with stable earnings, high quality operations, and strong balance sheets free of excessive debt gives Amana a tilt toward quality, which is now recognized in academic circles as a worthwhile risk premium factor.[3]

In addition, Amana prefers to hold shares in companies where management has a sizable stake, and the fund will sell shares in companies where insiders are selling. There is a body of academic literature confirming that insiders are better informed and earn abnormal profits from their trades.[4] Amana has an expense ratio of 1.14, plus .25 in 12b-1 fees. However, institutional shares (MUTF:AMINX) are available with an expense ratio of .90 and no 12b-1 fees. These require a minimum investment of $100,000.

Here are performance figures through February 2015 for our three sustainability funds starting from July 1986, when performance data begins for Amana. We also include the Vanguard 500 Index Fund (MUTF:VFINX) as a benchmark. Vanguard 500 has an expense ratio of .17 [5]

DRTHX PARNX AMANX VFINX
Ann Rtn 9.80 12.63 9.71 11.35
Std Dev 15.79 21.71 12.02 15.32
Sharpe 0.37 0.39 0.48 0.47
Max DD -59.98 -47.98 -34.70 -50.97

We see that Parnassus has a higher return than the S&P 500 with around the same maximum drawdown, while Amana has about the same Sharpe ratio as the market with a lower maximum drawdown. The lack of performance homogeneity among these funds is good for relative strength momentum. More separation in performance can create more opportunities for profits. So let us see now what happens when we apply dual momentum to these funds.

First though, I should mention a potential problem of using higher cost actively managed funds with dual momentum. The performance of actively managed funds may revert toward the mean of all funds and be overtaken by the performance of lower-cost index funds. However, this may not be such a problem for us here for two reasons.

First, we are not selecting actively managed funds based on superior past performance that might subsequently mean revert. We are simply using the three sustainability funds that have the longest track records. Second, we can easily include a low-cost stock index fund in our dual momentum portfolio. Dual momentum is adaptable. If there is a falloff in performance of our actively managed funds, dual momentum should automatically move us to the lower-cost index fund. This is why we can confidently use actively managed funds within a dual momentum portfolio framework.

Performance Results

Here is the same performance we saw above, but with the addition of a dual momentum portfolio made up of all three sustainability funds, the Vanguard 500 index fund for the reason given above, and the Vanguard Total Bond Market Index Fund (MUTF:VBMFX) as a refuge when absolute momentum takes us out of equities. The operating logic behind this model that we call ESG Momentum (ESGM) is the same as for our Global Equities Momentum (NYSEARCA:GEM) model. It is fully disclosed in my book, Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk.

DRTHX PARNX AMANX VFINX VBMFX ESGM
Ann Rtn 9.80 12.63 9.71 11.35 6.48 16.91
Std Dev 15.79 21.71 12.02 15.32 3.90 13.96
Sharpe 0.37 0.39 0.48 0.47 0.69 0.87
Max DD -59.98 -47.98 -34.7 -50.97 -5.86 -22.73
% Used 12 35 13 17 23 100

Results are hypothetical, are NOT an indicator of future results and do NOT represent returns that any investor actually attained. This is not a recommendation to buy or sell any security. Please see our Disclaimer page for more information.

We see that the Sharpe ratio of our ESGM portfolio is more than twice as high as the average Sharpe ratio of the four equity funds, and the ESGM maximum drawdown is less than half as large. By being in bonds 23% of the time, ESGM was able to bypass the full severity of the bear market drawdowns.

ESGM was in the three sustainability funds 78% of the time that it was in equities, so our mission was accomplished of being mostly in investments that contribute to advancements in social, environmental, and governance practices, while simultaneously giving us exceptional risk-adjusted returns through the use of dual momentum. A link to the ESGM model's monthly and annual results is now on the Performance page of our website. It will be updated monthly along with the rest of our dual momentum models.

[1] The two social responsibility ETFs, KLD and DSI, began in 2005 and 2006, respectively.
[2] PAX World Balanced began in August 1971 and CSIF Balanced Portfolio began in October 1982, but both funds have large allocations to bonds.
[3] See Asness et al. (2013), "Quality Minus Junk."
[4] For example, see Seyhun (1998), Investment Intelligence from Insider Trading.
[5] We could have used Vanguard's Admiral shares with an expense ratio of .05 or a low-cost S&P 500 ETF, but we wanted to be consistent with the retail shares we used for our socially responsible funds.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.