The Gains From 'Socially Responsible' Investing Are Non-Existent

"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." - Milton Friedman

Friedman’s sage economic observation has for many years guided investment managers who sought to provide their clients with the greatest return on their investments. Recently, however, many investment advisors have chosen to pursue what is commonly known as “Socially Responsible Investing” – and in particular ESG (Environmental, Social, Governance) investing.

The theory behind this investment strategy is that one can invest in “politically correct” companies that don’t supposedly pollute the environment or treat their employees unfairly and maintain a socially diverse work environment, all while providing their investors with a healthy return. In other words, allow their investors to “Have a Coke and a Smile” (Except that according to some, investing in Coke-a-Cola would not be Socially Responsible Investing as its consumption can lead to obesity and diabetes).

Other companies that SRI/ESG investors seek to avoid are those that produce significant carbon dioxide emissions, tobacco, alcohol, and weapons producers, or those with socially unpopular labor practices; The uber-politically correct Apple corporation would fall under this last definition based on their production facilities in Asia.

But can these investments really create the same rate of return as non-ESG investments, and do they actually support the causes they propose to promote? The data is, at best, unpersuasive. A study by Advisor Perspectives suggests that SRI/ESG investing results in lower than normal returns:

“New evidence from one of the world’s largest sovereign wealth funds shows that those investors are sacrificing significant performance…(w)hile SRI and ESG investing continue to grow in popularity, economic theory suggests that if a large enough proportion of investors choose to avoid “sin” businesses, their share prices will be depressed. They will have a higher cost of capital because they will trade at a lower P/E ratio, thus providing investors with higher returns (which some investors may view as compensation for the emotional “cost” of exposure to offensive companies).”

Meanwhile, research suggests that the financial losses engendered are not necessarily offset by proportionate social benefits.

“More broadly, the evidence of the efficacy of Environment, Social, Governance (ESG) investing is mixed at best. On the affirmative side, Edmans (2011) and Kahn et al (2016) show some evidence of higher returns along selected dimensions of social responsibility. On the negative side, it is well-established that “sin” stocks frequently outperform (see Hong and Kacpercyk, 2009 or Dimson et al, 2015). The debate is unlikely to be resolved in the near future; after all, there is still disagreement on the value of active management in general after nearly 50 years of research (see Jensen, 1968 and Ellis, 2015). Financial performance is clearly important, but the most fundamental motivation for ESG is ethical and social performance. We focus on the “S” (social) dimension and specifically the occurrence of regulatory actions, legal challenges, and other forms of reputational damage. Like most observers we expected common ESG practices to be associated with better social performance. We were wrong. Firms that disclose the widest range of socially responsible policies such as signing the UN Global Compact, disclosing “family friendly” employment policies, and monitoring suppliers’ labor practices, are much more likely to experience ethics controversies and adverse regulatory actions in the future.”

While not conclusive, there is significant evidence to suggest the SRI/ESG investing does not always provide the same rate of return as normal investments nor does it necessarily afford the investors the socially responsible governance they seek to achieve.