‘Sin Screening’ Is Ineffective at Best, Harmful at Worst

May 27, 2004 | Read Time: 8 minutes

Related articles: View all of the advice and commentary from this special supplement on endowments
By KEVIN HASSETT

Our rich and free economy produces a wide variety of products. Some, like antibiotics, clearly serve the common good. Others, like alcoholic beverages, do not. Most adults are used to making choices about their own consumption of unwholesome products. But in the era of mutual funds and 401(k) retirement plans, we have also come to grapple with our collective investment in such commodities. Is it OK to invest in companies that profit from bad behavior, or only in companies that are, by some common measure, virtuous?

We are not addressing, mind you, the ethics of a company’s management. My own rule is to sell a stock as soon as it is apparent that I cannot trust a company’s executives, whatever the purpose of the business. The issue, rather, is whether it is acceptable to buy shares of companies that profit from what one might call — literally or figuratively, depending on your outlook — sin.

The market being what it is, you can find all the sin you might wish for with one-stop shopping. The Vice Fund, for example, has been investing in “sinful” companies since August 2002. Its strategy is straightforward: Human foibles like drinking and gambling are fairly steady sources of profit. While manufacturing may tank in a recession, gambling and tobacco profits do not. Thus a portfolio filled with such companies may provide a steadier source of return than one that omits them. While the history of the Vice Fund is fairly short, its strategy so far has proved to be terrific. The fund is up about 7 percent so far this year, and 57 percent over the past 12 months. Both returns have trounced the market averages.

On the flip side, many funds have emerged that sift out the kinds of companies the Vice Fund seeks. For example, the VT Calvert Social Investment Fund Equity Portfolio is part of a family of funds that use ethical criteria to select investments. This year it has returned only 0.46 percent, and over the past 12 months only 23.86 percent.

While those two examples suggest that sin pays, investors should be cautious in drawing any conclusions from such a small sample. The Domini 400 Social Index, which excludes companies that earn their profits from alcohol, tobacco, firearms, nuclear power, or weapons, has almost exactly the same return over the past year as the Standard & Poor’s 500, and has slightly outperformed the S&P since KLD Research & Analytics began tracking the index in May 1990.

Trickier might be the practical conundrum of deciding how limiting an institution’s members might want the sin screen to be. A gun-control group, for instance, could be expected to screen for gun manufacturers, but would it necessarily have a consensus on whether to invest in manufacturers of larger military weapons, or nuclear power, or wineries?

It will be many years before a reliable track record is established. But for now, from the point of view of a nonprofit institution’s endowment manager, socially responsible investing raises two important questions:

What are the costs and benefits to the institution of adopting a so-called sin-screening strategy?
Is it likely that such a strategy will have an effect on the world at large?

Let’s look at each question in turn.

The efficient-market hypothesis states that it is impossible for any specific strategy to outperform the market. While some strategies may have worked in the past, it is unlikely that they will again, or if they do, that an investor will be able to predict when. The reason is simple: If the “Dogs of the Dow” (to name one popular former strategy) outperform the market, then everyone jumps in and buys them. That bids up the price and makes future appreciation less impressive. The efficient-market hypothesis works in reverse as well. If some strategy failed miserably in the past, that doesn’t mean it will fail again.

While the efficient-market hypothesis has suffered around the edges in the recent academic literature, it remains a reliable guide to our first question. It is unlikely that the adoption of a socially responsible investment policy would lead to lower returns, because if that were true, the arbitrageurs would reliably take the opposite approach — short-selling socially responsible stocks — until the profit opportunity was exhausted. In other words, if an institution’s managers want to invest its endowment in that manner, they can do so without losing too much sleep over the costs. That would not be true if the list of socially responsible investments were so short that endowments found themselves poorly diversified. But my own inspection of lists like the Domini 400 suggests that that is not a problem. In fact, it is surprising how many companies survive the morality gantlet.

If the costs to a nonprofit institution are low, however, the benefits are mostly psychological. An endowment manager, or an institution’s supporters, might find some peace of mind. They might also avoid harmful publicity. An environmental organization probably doesn’t want to be found to have invested heavily in the shares of a well-known polluter, and an animal-rights organization might think twice about buying into a tour company specializing in luxurious hunting safaris.

In a more practical sense, sin screening probably won’t have any impact on the markets. Relying on efficient-market theory, the value of each publicly traded company is the present value of the cash flow that it will earn from now until it goes bankrupt. No evidence suggests that investment fads will significantly affect that value. Casinos and tobacco companies, for instance, are currently priced on the basis of the profit that market participants expect them to earn. It is implausible that the investment policies of nonprofit organizations would significantly change smoking and gambling behavior or the profits of companies that meet those consumer demands. Even if socially responsible investing affected equity prices, debt finance would still be an option for the casinos and cigarette manufacturers.

In short, the first-pass economist’s answer is that socially responsible investing is a strategy that an investor can follow at little cost, but that won’t have much market effect. So, since it makes fund managers feel so lovely, why not salute it?

Well, because it’s a terrible idea. To the extent that funds are invested in equities, they need to be as broadly diversified as possible. While the Domini list is pretty broad, that is probably because the criteria are not very stringent. If funds take a more aggressive stance, they will inevitably exclude a large segment of the marketplace and give up valuable risk-reducing diversification.

But suppose I’m wrong, and socially responsible investment really does have the effect that its advocates intend. Then the story becomes even worse. Say that a wave of socially responsible investing takes over America’s nonprofit institutions, and that enough other investors adopt the practice that they drive down the prices of “sinful” companies. Those companies will then have a higher cash flow relative to their price, and as a result can be expected to outperform the market in the future. If only sinners buy those stocks, then sinners will be the investors getting the high returns.

Now imagine that you are sitting on a board of an organization that provides AIDS drugs to poor Africans. If you invest your endowment in socially responsible companies, then you might be able to help a million sick patients next year. If you invest in irresponsible companies and earn the higher return, then you could help perhaps 1.1 million. Could anyone really argue that it is ethical to leave 100,000 individuals without treatment because of socially responsible investment? While the example is an extreme one, the point is that anything that diminishes the quantity or reliability of cash available to nonprofit organizations is likely to have significant human costs. Don’t managers then have a responsibility to maximize the return on their endowments?

Of course they do. That’s not to say that emphasizing sin is a prudent public-relations move. But investing in broad indexes will accomplish the same thing, with little risk of negative publicity.

After all, there are two possibilities. Either socially responsible investing has no effect, in which case it is just window dressing, or it does have an effect, in which case it’s an awful idea. Either way, for my part, I hope that my favorite charities — even the religious ones — invest some of their endowments in the Vice Fund.

Kevin Hassett is director of economic-policy studies at the American Enterprise Institute, in Washington.

ONLINE RESOURCES

Here are sources of online information about socially responsible investing:

GENERAL INFORMATION

Institutional Shareholder Services:
http://www.issproxy.com

Interfaith Center on Corporate Responsibility comprises 275 faith-based institutional investors that sponsor more than 100 shareholder resolutions a year:
http://www.iccr.org

KLD Research & Analytics:
http://www.kld.com

Social Investment Forum, which provides a wide range of information and data on socially responsible investing:
http://www.socialinvest.org

SPECIFIC POLICIES

American Medical Association policies on tobacco stocks:
http://www.ama-assn.org/apps/pf_new/pf_online?f_n=browse
&doc=policyfiles/HnE/H-490.983.HTM

U.S. Conference of Catholic Bishops guidelines on socially responsible investing:
http://www.usccb.org/finance/srig.htm

U.S. Securities and Exchange Commission regulations requiring mutual funds to report their proxy-voting records, policies, and procedures:
http://www.sec.gov/news/press/2003-12.htm