Alternative factors to consider in evaluating Socially Responsible Investment performance

As an investment manager with Rocky Mountain Humane Investing (  the most common question we hear from potential clients is “and advisor told me that socially responsible investing isn’t profitable” versus unscreened portfolio management.   In general the advisor providing the dogmatic opinion does not offer any foundation for their opinion but this is their chance to influence the potential client especially if they cannot offer an SRI option for the investor.   Unless you have a few arrows of your own in your quiver you may be quite likely shrug your shoulders and resign yourself to an unscreened portfolio versus a clean portfolio.

Probably due to the fact that I’m over 50 now with a repellent view of hyperbole and unsubstantiated opinions I have been uncomfortable with opposite view as well: socially responsible investing improves rate of return.  It has been my view based upon empirical experience of managing SRI portfolios for 20 years that SRI is not a significant determinant of investment performance.   SRI is a highly subjective practice where investors can have divergent opinions on industries and companies.   There is not unified screening standard amongst the SRI industry, each firm or fund makes their own decisions on screening criteria.  While some funds screen for only 3 or 4 issues there are other funds that screen over a dozen.

Practitioners of SRI may draw attention that investors always assume a given level of risk with any equity investment but that the risk premium associated with SRI is less.    Case in point the risks associated with Tobacco, Asbestos or BP and the Gulf oil disaster.  However in my 20 years involved with socially responsible investing, screening stringency is often a matter of interpretation as BP was considered Best of the Lot for many years for funds that desired petrochemical exposure.

Let’s take a look at some of the academic studies that have touched upon the issue of the factors of SRI performance:

  • Moskowitz Award winner, John Guerard, Jr., director of quantitative research at Vantage Global Advisors, examined the returns of Vantage’s 1,300 stock unscreened stock universe  and a 950 screened universe (The screens eliminated companies that failed to pass alcohol, gambling, tobacco, environmental, military, and nuclear power). He found “that there is no significant difference between the average monthly returns of the screened and unscreened universes during the 1987-1994 period.  The “unscreened 1,300 stock universe produced a 1.068 percent average monthly return during the January 1987-December 1994 period, such that a $1.00 investment grew to $2.77. A corresponding investment in the socially-screened universe would have grown to $2.74, representing a 1.057 percent average monthly return. There is no statistically significant difference in the respective returns series, and more important, there is no economically meaningful difference in the return differential.”

Guerard’s conclusions are reinforced by other works:

  • “Socially Responsible Investment: Is it profitable” Dhrymes, Columbia University July 1997 June 1998.Dyrymes concluded that: “that by and large the Concerns and Strengths of the KLD index of social responsibility are not consistently significant in determining annual rates of return.”

  • Socially Responsible Investment Screening Strong Empirical Evidence For Actively Managed Value Portfolios.  June 2001, revised December 2001 Stone, Guerard, Gultekin, Adams.“No Significant Cost” means no statistically significant difference in risk adjusted return”. In addition, they surmise that “the conclusion of no significant cost/benefit is not just a long term average.  It has remarkable short term consistency!”

In my opinion this report presents a balanced view in that they concluded that the during the time of the study 1984-1997 the stock market rewarded the growth oriented style and that the performance of SRI investments could become “brittle” if markets were to become risk averse and adopt a more Value oriented style……….a remarkably accurate presumption!

Could the performance of SRI funds which have exceeded or lagged their respective benchmarks be in part due to size (average capitalization from micro cap to large cap) and style (Value or Growth)?

Fama and French of Dartmouth University examined the annual rate of return and beta (volatility) of an unscreened universe of Growth vs. Value from 1928 to 2009 by dividing stocks into ten deciles (groups) based on book-to-market value, rebalanced annually and found that Value had the lower risk while Growth had the higher risk.  In addition, they found that the highest book –to-market stocks exceeded the return of the lowest book-to-market by 21% to 8% on average.   Stock valuation was as significant factor in the Fama and French study where the cheaper the equity valuation the better the return.

Market Cap size was important in the Fama and French study as well (1992).   Market cap size showed a significant edge to small and micro cap equities on a monthly basis.  *Monthly returns for the smallest 10% of equities were 1.47% versus 0.89% for the largest decile.

It is our contention that there are attributes that could account for performance to equities other than social profiles and that concurrently a portfolio of socially screened equities with the highest book-to-value ratios could exceed comparative benchmarks largely due to valuation metrics and capitalization size.   In a case of pure cherry picking the monthly rate of return smallest market cap and lowest book value to market price was 1.63% versus .93% monthly for largest market cap and highest book value to market price.

I tested this theory using data supplied by the Social Investment Forum and Russell Index regarding the 10 year average rate of return for socially responsible mutual funds versus their respective benchmarks trends do emerge.

Data as of June 30, 2010


  • Russell Mid Cap Value Index was the top 10 year performer +7.55%.
  • Russell Mid Cap Growth Index returned -1.99%.
  • Russell 2000 Value returned +7.48%
  • Russell 2000 Growth Index returned -.92%

Equity Large Cap performance (information provided by SIF)

  • 4 mutual funds show positive 10-year average annual rates of return:
    Calvert Social Investment Equity +0.14% (Growth)
    Neuberger Berman Socially Responsive +3.18% (Value)
    Walden Social Equity +1.46% (Value)

Parnassus Equity Income +4.65% (Value)

Equity Small Cap performance

  • 2 mutual funds from one mutual fund company showed a positive 10-year rate of return.
    Ariel Appreciation +6.16% (Value)

Ariel Fund +5.62% (Value)

Disclaimer: While the sample size of SRI fund performance is very small.  I gleaned data from only the profitable SRI funds for the last 10 years.   The SIF forum does not show fund performance information for funds that have closed, merged or liquidated.   It would be a safe presumption IMO that funds that no longer exist were weak performers since money will flock to where it’s treated best.   Plus, hedge fund performance data was not available on the SIF site.

The results do fall in line with substantial academic works (Fama and French, Lakonishok) and it is possible that SRI performance should be viewed thru the lens of Value/Growth and Market Cap size.

A logical question that must be asked upon reading this might be: “If small market cap and low valuations are the sweet spot for investing, then why are there so few funds or managers focusing on this strategy?”  Not to be obvious…………ok, well lets be obvious:  The small cap / low price to BV tends to be the focus of many private portfolio managers since our small size allows us the dexterity to invest in companies that are simply too small for billion dollar mutual funds.  Successful funds tend to outgrow the size/valuation strategy espoused by Graham as assets become larger and the investment selection becomes narrower.  But this topic should best be explored at a later date.

No holdings mentioned

Brad Pappas
President of Rocky Mountain Humane Investing
Allenspark, Colorado

RMHI 4th quarter client letter

Summary: The epic rally of the past 7 months has appears to have hit a wall at 1100 on the S&P 500.  This does not mean we cannot rally beyond 1100 or that the market must now decline, trending sideways for a period of months may be the likeliest scenario.  The time period of November to April is historically the strongest six months of the year, particularly November and December, so strength into the year- end is a possibility.  Lowry’s Research has stated they expect the current pullback to be short term.  Our strategy of Small Caps over Large Caps is still in force although I’m reviewing future holdings as the weaker Dollar tilts the odds to favor Large Caps.  My thought is that going forward the disparity between Small and Large Cap stocks will narrow.  The US stock market is no longer “Undervalued” but merely “Fairly Valued” in my estimation we are reducing exposure to stocks periodically on strength which I expect by December.

Back in the Spring I proposed that the stock market would initiate a rally of historic proportions with a target of 1100-1150 sometime in 2009.  This prediction was based on past precedents the belief that no one at the time was discounting the end of the recession by Summer.  This target was breached on October 21st.  While I consider the stock market now fairly valued, the signs of a classic major top in the stock market are simply not present at this time.  The current pullback has the ingredients of a short-term correction rather than the start of a new leg down.  Major tops take time to develop and our timing service Lowry’s points out that “Every major market top in Lowry’s 76 year history has been preceded by a sustained rise in Selling Pressure.”  There is no evidence of a sustained rise in Selling Pressure at this time.

Adding to the lack of incentive for a new down-leg in stock prices is the fact that interest rates are at minimal levels and while market valuations are fairly valued at 14.5 normalized earnings, which is about 2 multiple points less than historical averages.  Since 1932, the six months after the end of the recession has seen gains on average of 9%.  Curiously, the two market years most resembling the past year: 1938 and 1975 saw gains of only 3% for the next six months after the end of the recession.  In addition, small cap outperformance is maintained by an average return of 7% in the six months following the end of a recession.  The issue of Small Cap outperformance is subject for review due to the effects of the declining dollar.  A declining dollar assists the performance of Large Cap stocks.  Small Caps peaked on September 19 and if the trend of Small Cap’s lagging performance persists for another month, future additions will be Large Caps.

Believe it or not we’re going to get an economic recovery, it may be anemic by historical standards but it will be a recovery.  Due to the stimulus package there will be a significant infrastructure build out in the US starting in 2010.  Warren Buffet’s purchase of Burlington Northern is a classic smart move to get in front of the infrastructure build.

The 3rd Quarter of 2009 turned into quite a prosperous quarter for RMHI clients as our exposure to small cap equities with international diversification has been a winner since the market bottom in March.  While the past few months have been quite good, I believe that going forward gains will moderate especially if we stay in a trading range with 1100 on the S&P 500 being the top end of the range.

Historically speaking, the period post-recession has produced gains but to a lesser degree than the period preceding the end of the recession.  In other words, its likely that the “easy money” has been made (as if its ever “easy”!) but there still are gains to be made although our exposure to equities will be reduced as the risk reward is not quite what it was in March.  There is always the chance that unknown world events could throw a Molotov cocktail into the markets, so having cash off the table could prove to be prudent.

Until there is solid revenue growth in the US, my view is that we could be entering a period of market digestion, not unlike what we experienced in 2004 (the SP 500 did return +8% in ’04).  Gains were still made just not nearly at the rate in 2003.  Small cap GARP (Growth at a Reasonable Price) should still outperform, just at a lesser pace.

It seems to me that in the past 10 years we’ve bounced from Bubble to Bubble which eventually pop sooner or later.  The current interest rate environment is unsustainable in my view, but the hazards of reaching for yield by going out farther and farther on maturities could be the next major bubble to pop.   Timing is next to impossible to predict but it could be within the next two years.

The current 0% interest rate environment induced by the Federal Reserve has created a curse on holding cash.  The 0% return is forcing investor’s including retirees to invest in increasingly longer term maturities to gain incremental increases in yield.  Desperate to increase their yield they’ll be very vulnerable to a pullback in bond prices.  While the Federal Reserve controls the yield and price of short term Treasures, market forces have a much greater influence on longer term maturities and the Fed’s support of Treasury prices will eventually end.  Fear continues to guide their decision making as equities were almost completely avoided this Spring which means they missed the 20% + returns in favor of bonds yielding 2%-4%.  The lure for this move is the perception of “safety” but in the longer term this perception could be a very elusive mirage.

The catch is that our deficits and issuance of debt is having a declining effect on the dollar and at some point investors, especially foreign investors will demand higher rates for the risk of owning Treasuries.  While the debate over future inflation is mute at this point, my view is that eventually interest rates must go higher eventually, especially if we experience declines in unemployment in 2010.   What would happen to the prices of long term debt should rates rise to 7% or even 9%, the collapse in bond prices for those investors would be devastating.   This is the basis for my belief that should employment rebound in 2010 or 2011, it could be accompanied by a significant pullback in stock prices, which would take their cue from falling bond prices and higher yields.

I realize the returns on short-term debt are almost next to nothing, but the risk inherent in owning short-term debt during an interest rate spike is not nearly as significant as longer-term maturities. I’d rather be safe with our ownership of short-term bonds rather than the higher yielding long-term maturities.  Short term interest rates are set primarily by the Federal Reserve and its my view that those rates will not rise until a meaningful increase in employment is underway, this could remain elusive for most if not all of 2010.

While the declining US dollar presents problems longer term for US interest rates there are positive ways to invest with a weaker dollar in mind.  Generally a weaker dollar is positive for US equities, especially Large Cap Growth stocks like Apple or Google.  Both of these stocks rank very high in our model so they’ve been mainstays this year.  In addition, countries and regions that are commodity oriented such as Latin America.  Foreign Treasury bonds are another good option and we’ve owned them for most of the year.  Gold is another interesting way to prosper from the declining dollar.  With the resumption of risk appetites worldwide investors are liquidating dollars and transferring the assets to Gold.  Gold also plays a valuable role in the event of a crisis that could erupt in the Middle East should Iran remain contentious regarding its nuclear plans.

All The Best,
Brad Pappas