Socially Responsible Investing (SRI) not only considers the financial return, but also takes into consideration the non-financial concerns of investors such as environmental, social, and governance issues known as ESG factors. General belief among investors is that conventional portfolios must outperform Socially Responsible (SR) portfolios. This belief is based on the Modern Portfolio Theory (MPT). Based on MPT if we put a constraint on the universe of available securities, the risk-adjusted return will be lower than/equal to the risk-adjusted return of a portfolio without that constraint. However, when we compare the performance of SR portfolios with conventional ones, not only we don't see this under-performance, but also we see out-performance in many instances.
In the two below figures, we see the performance of Jantzi Social Index (JSI) and MSCI World SRI Index compared to their corresponding conventional indices. JSI was launched in January 2000 in partnership with Dow Jones Indexes. It is a socially screened, market capitalization-weighted common stock index modeled on the S&P/TSX 60 consisting of 50 Canadian companies that pass broad set of ESG criteria. The MSCI World SRI Index is a capitalization weighted index that provides exposure to companies with outstanding ESG ratings and excludes companies whose products have negative social or environmental impacts. The Index is designed for investors seeking a diversified SRI benchmark comprised of companies with strong sustainability profiles while avoiding companies incompatible with values screens.
Figure 1: Performance of Jantzi Social Index (JSI) in comparison to S&P/TSX Composite and S&P/TSX 60 (Resource: Jantzi Social Index)
Figure 2: Performance of MSCI World SRI Index in comparison to MSCI World Index (Resource: MSCI KLD 400 Social Index - MSCI)
As we can see in Figure 1 and Figure 2, JSI is outperforming/tracking both S&P/TSX Composite and S&P/TSX 60 on a total return basis. MSCI World SRI Index is also outperforming/tracking MSCI World Index on a total return basis. Comparison based on Total Return can be misleading since risk is not considered. In addition, S&P/TSX Composite and S&P/TSX 60 may not be the best benchmark for JSI, and MSCI World Index may not be the best benchmark for MSCI World SRI Index.
To shed light on the difference in the performance of SR and conventional portfolios, I compare the performance of JSI on a risk-adjusted basis with a conventional portfolio that matches JSI based on industry and size. For size, I use total assets, and for industry, I use NAICS (North American Industry Classification System) codes. I've updated the matched portfolio through time in case of any changes in the constituents of JSI. The results of the performance comparison can be seen in Table 1. This comparison is done in the period between March 2003 to December 2015.
|Abnormal return (based on CAPM)||0.567%||0.100%|
|Abnormal return (based on Fama-French model)||0.572%||0.101%|
Table 1: Results of my analysis (Resource: My own calculations)
As we can see in Table 1, JSI outperforms the matched portfolio on a risk-adjusted basis using measures such as Sharpe ratio, M-squared, Treynor ratio, and T-squared. JSI also has a higher abnormal return (alpha) compared to the matched portfolio using both CAPM (Capital Asset Pricing Model) and Fama-French model. Another important factor in this comparison is leverage ratio. We need to compare this factor to make sure that differences in leverage ratio has no effect on the differences in performance. As we can see, the two portfolios have very close leverage ratios. Economically, 1% difference in leverage ratios does not have any major influence in performance differences. The results of Table 1 shows that SR portfolios can be more profitable than conventional portfolios.
There is a possibility that the results in Table 1 are affected by the study period, models, and data set. To analyze the response of the market to SRI while removing the effects of the factors mentioned, I perform an event study. This event study is designed to investigate the response of the market to the inclusion of companies to JSI and exclusion of companies from JSI. I use a measure called Cumulative Average Abnormal Return (CAAR) to see how market responds to inclusion to or exclusion from JSI. CAAR measures the accumulated abnormal returns across those companies that were affected by the same event (inclusion or exclusion).
For this event study, I use an event window that constitutes of the event day (day 0), 20 days before and 20 days after the event day. For companies that were included to JSI since its inception, I was not able to find a significant pattern for CAAR. However, as we can see in Figure 3, CAAR for excluded members show a negative pattern. In this figure, for those days in the event window that CAAR is not significant, no dots are shown. The most important days in the event window are the immediate days before and after the event day. As we can see, CAAR for these days are significantly negative which shows that exclusion from JSI is considered to be a negative event for companies. In other words, on average, those companies that were removed from JSI have experienced negative returns, which shows that being considered as non-socially responsible has adverse effects on the performance of a company.
Figure 3: Results of the event study (Resource: My own calculations)
All in all, the above analysis shows that not only being a socially responsible investor does not result in a lower risk-adjusted return, but it can also lead to out-performance. In other words, investors can remain socially responsible and at the same time receive higher abnormal return. As a result, SRI can be considered a profitable portfolio strategy.