The Cost of Socially Responsible Investing
Last updated
Last updated
As we evolve into a more political and environmentally conscious society, the concept of “socially responsible investing” is becoming an increasingly popular investment option. A socially responsible investor is one who chooses not to invest in certain companies whose behavior they judge to be at odds with the social good as they perceive it. Some proponents of socially responsible investing claim that “good” companies – those in harmony with the social good – perform as well or better than “bad” companies. They conclude, therefore, that socially responsible investing is without cost and may even enhance performance. However, one may argue that if the motive to invest is due to higher expected returns, it is not in fact “socially responsible” investing.
As with any method of investing, it is important to be aware of the costs. Suppose, for example, that exclusion of tobacco companies reduces return. Some may argue that this cost is worth incurring because it focuses attention on the issue, or because it may influence company behavior. Others may argue that it would be more effective to collect the return of the tobacco investment, and deploy it directly towards policies designed to curb smoking or treat lung cancer. Without knowledge of the expected cost, it would be difficult to accurately evaluate this trade-off.
We employ a Monte-Carlo simulation.
We use this technique to compare the performance of a skilled investor without restrictions with the performance of a skilled investor with restrictions (a socially responsible investor).
We simulate the cost of socially responsible investing under various scenarios. We vary the investment universes to model four common benchmarks: the S&P 500, the MSCI EAFE, the MSCI World, and the MSCI All Country World Index. We select portfolios of 100 and 250 securities, assuming a variety of skill levels. Additionally, we estimate the costs associated with excluding 10%, 20%, and 30% of the securities due to not meeting socially responsible criteria.
As you can see in Exhibit 1, an investor with 52% skill who selects from a universe comparable to the S&P 500, and who foregoes investment in 10% of the securities, should expect to give up 0.08% annually to an investor of the same skill, who is not socially responsible. This cost rises with the investor’s skill level, the number of excluded securities, and the cross-sectional dispersion.
Exhibit 2 reveals that the cost of socially responsible investing rises with the number of securities in the portfolio. For instance, an investor with 54% skill who selects 100 securities from a universe similar to the S&P 500 incurs a cost of 0.37% when excluding 20% of the securities. If this investor increased the number of securities from 100 to 250, the cost would rise to 0.53%. This is because the investor must substitute progressively lower ranked securities as she expands the number of securities in the portfolio.
Of course, when expressing cost in terms of percentages, it can be challenging to truly understand the impact. Exhibits 3 and 4 convert those percentages into their cumulative dollar values. These tables assume:
100 or 250 securities
52% skill
20% exclusion
An initial portfolio value of $1 billion
An underlying market return of 8.0% for periods of five, ten, and twenty years
These tables reveal a harsh reality about socially responsible investing. A socially conscious investor can either exclude “bad” companies from their portfolio and sacrifice vast sums of wealth, or invest in an unrestricted fashion and deploy those returns directly toward reforming those social wrongs.
Based on the results of a Monte-Carlo simulation comparing socially restricted investments against unrestricted investments, it is clear that the cost of socially responsible investing is substantial — even for skilled investors.
