From AQR's Cliff's
Virtue is its Own Reward: Or, One Man’s Ceiling is Another Man’s Floor
Negative screening is a common application of Environmental/Social/Governance (ESG) investing. It avoids “sin stocks” and divests from industries or firms deemed immoral or having poor or undesirable standards along one of the three E, S or G dimensions.1 It’s promoted largely on the fact that it’s virtuous. While we may all define virtue differently, advocating for it in this way is fair and appropriate. However, employing these constraints is also often promoted as enhancing expected returns. That is, if you avoid certain companies, industries, and even countries, that are deemed non-virtuous, you should expect to make more money over time.2 Do good and make the same return or more! This is mostly wrong and, more the point here, actually at odds with the very point of ESG investing. Pursuing virtue should hurt expected returns. Some have discussed this fact.3 But, it’s still not widely understood or broadly accepted. This seems to arise from investment managers selling virtue as a free lunch, and from investors who very much want to believe in that story. In particular, and my focus here, accepting a lower expected return is not just an unfortunate ancillary consequence to ESG investing, it’s precisely the point (though its necessity may indeed be unfortunate). As an ESG investor this lower expected return is exactly what you want to happen and really the only way you can affect the change you seek.4,5...MORE
First there’s the very basic thing. Constraints can never help you ex ante and only sometimes ex post through luck. Why? Because if they help they aren’t constraints, they are what you want to do anyway. So, if you say your portfolio is better with a negative screen, you are saying that the old evil you who didn’t care about ESG issues also didn’t like more money.6 Many commentators do indeed seem to (implicitly and sometimes explicitly) say that constrained portfolios are ex ante better. The opposite, that judged purely on return and risk constrained is always ex ante less than or equal to unconstrained, is really an important concept and still surprisingly often misunderstood. Constraints are needed to push you to do things you otherwise would not do, not to do things you’d do anyway out of self-interest.7,8
Put simply, if two investors approach an asset manager, one who says “just maximize my return for the risk taken” and the other who says “do that but subject to the following constraints,” it is simply false and irresponsible for the asset manager to assert that the second investor should expect to do as well as the first, except in the case where those constraints are non-binding (and therefore not relevant). Even in that case, it’s still irresponsible to say that the second investor should expect to do better (again, if this is just a trade it’s a consistent view but the ESG negative screening program has zero to do with it as you’re doing what you’d do otherwise out of greed!).
But, while important and sometimes misunderstood, the argument that ex ante constrained is less than or equal to unconstrained is actually rather trivial. The more interesting thing is precisely how ESG investing really makes an impact. It turns out that the ESG investor making less and the slimy sin investor making more, than they all would in the absence of the ESG investor’s self-imposed constraints, is precisely what the ESG investor wants to happen. That’s kind of cool in a math-econ-geek sense (as we’ll soon see as a human it’s kind of annoying).
What happens when one group of investors, call them the virtuous, simply won’t own a segment of the market (the sin stocks)? Well, in economist terms the market still has to “clear.” In English, everything still gets owned by someone. So, clearly the group without such qualms, call them the sinners, have to own more than they otherwise would of the sin stocks. How does a market get anyone, perhaps particularly a sinner, to own more of something? Well it pays them! In this case through a higher expected return on the segment in question. This may be unpleasant but it is just math (like math could ever be unpleasant). In the absence of extra expected return the sinners would own X of the market segment in question. The only way to get them to own X+Y is to pay them something more. Now, assuming nothing else changed, how does the market assign this sinful segment a higher expected return? Well by according it a lower price. That is, if the virtuous decide they won’t own something, the sinners then have to, and they have to be induced to through getting a higher expected return than otherwise. This in turn is achieved through a lower than otherwise price.9,10
Now for the fun part. How do the virtuous actually make the world a better place? Well to make the world a better place you want the sinning companies to sin less not just to suffer in the stock market. Does the above deliver this desired effect? Yep. Imagine a sinful company is considering a new investment project. How does it analyze this project? Well, as many of us were forced to learn in business school, it forecasts out cash flows, both positive and negative, and discounts those cash flows back to the present. If the final number is positive (a positive “NPV” in the parlance), and simplifying a bit for other complications like mutually exclusive projects, it undertakes the venture. Now I snuck in the assumption that the company knew the forecasted cash flows and the discount rate. I’m going to stick with the first assumption, that the actions of our virtuous and sinful investors don’t affect the forecasted cash flows of this potential project.11,12,13 But we can’t make this assumption for the discount rate as we know it is false and we know in which direction it’s false. Discount rates are in fact expected returns (and this is where we get our essay’s sub-title cut from Rhymin' Simon as one man’s discount rate is another expected return). Earlier we showed that investors will demand a higher expected return from the sinful companies, due to shunning by the virtuous and the necessity to bribe the sinners to hold more of them.
It also directly follows that the sinful companies will have to use a higher discount rate (or, perhaps more clearly in this case, “cost of capital”) in their “should we undertake this project?” calculations. This is truly Finance 101.14 That means quite simply that fewer sinful projects will show positive NPVs and fewer will be undertaken.
Put simply, if the virtuous are not raising the cost of capital to sinful projects, what are they doing? How are they actually affecting the world as they wish to? If the cost of capital isn’t also an expected return, what is it?...
From April 2007 (hey, we're nothing if not patient):
Moral Judgment On 'Sin Stocks' Means Higher Returns For Vice-Friendly Investors
That's the headline of a press release from the University of British Columbia's Sauder School of Business announcing the release of a draft paper by the school's Prof. Marcin Kacperczyk and Princeton Economics Prof. Harrison Hong.
Prof. Hong lists his research interests as:
"Asset pricing with less-than-fully-rational investors; differences of opinion, short-sales constraints and asset prices; social interaction and financial markets; career concerns, biased forecasts and security analysts; organization, performance and mutual funds; asset pricing with asymmetric information and other market imperfections."Hey! Mine too!