by Louis Basenese, Advisory Panelist, Investment U
Thursday, November 9, 2006: Issue #604
Editor’s Note: The following is an excerpt from the November 15th issue of the Communiqué, The Oxford Club’s twice-monthly newsletter. Here, the Club’s IPO and Mergers and Acquisitions specialist, Louis Basenese, examines one of the fastest growing industry trends – social responsibility investing… and just how well these funds will treat your money.
The goal of business is to make money. Plain and simple. Or so I thought…
According to the latest research from the Social Investment Forum, an alarmingly large portion of investors is convinced otherwise.
To them – and their $2.29 trillion worth of capital – businesses should also assign significant weight to meeting various social and/or environmental criteria. If they don’t, the company is simply not worthy of investment. Or that’s at least how the socially responsible investor thinks.
But here’s some proof that, socially responsible investments, one of the fastest growing trends in the investment industry, has it all wrong…
Socially Responsible Investments Are Anything But “Smart Money”
To be sure, socially responsible investing (SRI) is no minor trend. At present, there are more than 200 SRI mutual funds and too many separately managed accounts to count.
In fact, based on 2005 figures from Nelson Information’s Directory of Investment Managers, roughly one in every 10 dollars under professional management in the U.S. is involved in SRI investing. In the past 10 years, assets under management surged 258%.
But don’t be fooled by the increasing popularity or large capital inflows. Considerable research demonstrates this is anything but “smart money.”
As Nobel-prize winner Milton Friedman put it in 1962:
“There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits, so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”
While I don’t think it’s bad for businesses to improve society, as Milton Friedman points out, by no means is it a requirement. Instead, it’s more like Adam Smith imagined it in The Wealth of Nations:
“By pursuing his own interest [an individual] frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”
To be clear, social responsibility is mostly a by-product of good business, not a motivating principle.
Nonetheless, in the early 1970s with the war raging in Vietnam, protesters found it deplorable that companies like Dow Chemical (the maker of napalm) were actually profiting from the conflict.
And that’s when the first SRI fund – the Pax World Fund – was born to combat the perceived irresponsibility.
I suspect it’s this perception as a positive change agent that’s attracting huge sums of money to SRI investing. But what few investors realize is that their noble endeavors to enforce social responsibility fails on several fronts…
How to Lose $174,000 With Socially Responsible Investments
If social responsibility is to be a primary goal for businesses, there should be some way to measure it. And aside from very subjective surveys, there isn’t one.
That’s why you’ll never see an analyst write: “Shares of Starbucks are worth at least $5 more because of the company’s commitment to improving water quality in impoverished nations.”
Put simply, social responsibility might be admirable, but that’s it. Companies won’t and aren’t sacrificing profitability to pursue it. And that’s because the only obligation they have is to increase shareholder value. Something easily and constantly measured in terms of profits and share prices.
Socially responsible investing also breaks down when you consider the significant costs for pursuing such an investment process. And since we invest to make money, this should be our utmost concern. Not only are expenses above industry averages, performance lags, too.
Research from the Wharton School in 2003 concluded investors who chose actively managed SRI funds sacrificed more than 3.5 percentage points a year in performance on a risk-adjusted basis.
And the more narrow the investment focus, the greater the sacrifice. For instance, the research showed an investor insisting on a small-cap value SRI fund lagged non-SRI funds by an eye-popping 18% a year.
Don’t be misled. While 18% is an unforgivable margin, 3.5% is no pittance either. In fact, based on a $100,000 nest egg and a 20-year time period, earning only 5.5% versus 8% annually translates into over $174,000 in lost profit.
In the end, SRI investors would be better off investing in the stocks they deplore and just donating their additional profits and the amount they save on expenses to their favorite charity.
Like I said, we invest in companies to make money, not to save the world. Plus, investing in so-called “sin” stocks doesn’t mean you endorse their products. Unless you’re buying into an IPO or secondary offering, not a penny hits the company’s coffers.