I just came across this story on CBS Money Watch segment: The issues with Socially Responsible Investing”.   My comments appear in parenthesis.

“MoneyWatch)  Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that you’re seeking not only profitable investments, but also investments that meet your personal standards. For instance, some investors don’t want to support companies that sell tobacco products or rely on animal testing. Of course, not everyone has the same set of beliefs, so SRI can mean different things to different people.

According to the Social Investment Forum, total SRI assets in the United States rose from $639 billion in 1995 to $3.07 trillion at the start of 2010. Clearly investors believe in SRI. One question for investors in SRI funds is: Is there a price to pay for avoiding “sin stocks”?

Expenses To answer the question, we begin by considering that SRI funds are typically more expensive than index funds and passive funds in general. One reason is that they incur the extra costs of screening out the undesirables. Those extra costs hurt returns.

(How and why is screening an extra expense, it isn’t with RMHI.)

Diversification SRI investors also typically sacrifice diversification. SRI funds typically are domestic and large cap. Thus, investors sacrifice exposure to small-cap and value stocks, and perhaps international and emerging market stocks as well. They also then lose exposure to the higher expected returns provided by small-cap, value and emerging market stocks.

SRI investors also may be accepting other risks. Because they avoid investing is “sin” stocks, they’re not fully diversified across industries.

(He has a major point here, but I feel like the kid in the back of his class with his hand raised and not being called upon by the teacher:  He is spot on regarding Small Cap and Value stocks, which is why we focus on them.    Several academic studies have proven small cap value to be an ideal combination.)

Cost of Capital There’s one other important point to consider. Economic theory tells us that because there are $3 trillion of SRI investments that avoid “sin” stocks, the cost of capital of sin stocks is driven higher than it would otherwise be, and the cost of capital of the non-sin stocks is driven lower. In other words, by avoiding investing in sin stocks, investors make those stocks cheaper (smaller and more value-oriented). And since the flip side of the cost of capital is the expected return to investors, SRI investors are missing out on the higher expected returns of “sin” stocks.

The authors of the study, “The Price of Sin: The Effects of Social Norms on Markets,” provide evidence that the hypothesis that there’s a societal norm against investing in “sin” stocks is correct, and that it does impact the cost of capital. The following is a summary of the findings:

• When compared to stocks of otherwise comparable characteristics, sin stocks have less institutional ownership — approximately 18 percent lower institutional ownership than comparable stocks (23 percent versus 28 percent).
• Sin stocks receive 21 percent less analyst coverage.
• Sin stocks are less held by norm-constrained institutions such as pension plans as compared to mutual or hedge funds that are natural arbitrageurs.
• The prices of sin stocks are relatively depressed, and, therefore, have higher expected returns than otherwise comparable stocks — consistent with them being neglected by norm-constrained investors and facing greater litigation risk (e.g., tobacco stocks) heightened by social norms.
• For the period 1965-2006, a portfolio long sin stocks and short their comparables has a return of 29 basis points per month after adjusting for a four-factor model comprising of the three Fama-French factors and the momentum factor. The statistics are economically significant. And just looking at a portfolio long sin stocks would yield even more significant out-performance of sin stocks relative to these benchmarks.
• The market-to-book ratios of sin stocks are on average about 15 percent lower than those of other comparable companies. These valuation ratios, using a Gordon growth model calibration, imply excess returns of about 2 percent a year.
• As out of sample support, sin stocks in seven large European markets and Canada outperform similar stocks by about 2.5 percent a year.

(Sin stocks, by and large and slow but consistent growers and have a tendency to do relatively well in recessions.  However, an alternative to owning sin stocks is to merely cut stock exposure when earnings estimates on the S&P  500 begin to show material weakness.   However, the author is using a simplistic “buy and hold” approach that is great in a secular bull market but is frustrating in a secular bear which we have today.)

The conclusion we can draw from this study is that social norms have important consequences in for the cost of capital of sin companies. They also have consequences for investors who pay a price in the form of lower expected returns and less effective diversification.

(He would largely be correct but he’s assuming there aren’t other methods of circumventing sin stocks as I’ve mentioned previously.  I’m starting to think that he’s “talking his own book”)

While many investors will vote “conscious” over “pocketbook,” there’s an alternative to socially responsible investing that’s at least worth considering: Avoid socially responsible funds and donate the higher expected returns to the charities that you are most passionate about. In that way, you can directly impact the causes you care most about and get a tax deduction at the same time!

(Or! Why not find a manager who uses Small Cap Value and can still post very good and competitive returns while still avoiding Sin stocks…..yes, now I’m talking my own book :)