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Is it “Bad” to be a “Good” Investor?
Kevin Davis
Commonwealth Bank Chair of Finance
Director, Melbourne Centre for Financial
Studies
Overview and Outline
Objective: outline and interpret recent evidence on
implications of SRI/ESG (“Good”) Investing
• Finance 101 – making sense of the evidence
• What are the questions?
• The evidence
– do “good” investors pay a price?
– what influence do good investors have?
– Do “good” companies do good well?
• A postscript: difficulties in being a “good” investor
in a complex financial world
© Kevin Davis
Almost/Slightly Efficient Markets
Don’t bother, if it really was
there, someone would have
picked it up already
Share prices reflect available information to some degree
© Kevin Davis
Almost/Slightly Efficient Markets
• Implications
– It is unexpected news/ changed opinions which cause
prices to change unexpectedly
• Such as announcement of an unanticipated penalty
scheme for emissions
• But not commencement of a widely anticipated penalty
scheme
– Share price of those likely to be adversely affected will
have previously fallen
– Being “ahead of the pack” (and correct) generates outperformance
• Correctness may relate to fundamentals or to just
identifying where the pack is going!
© Kevin Davis
Almost/Slightly Efficient Markets
• If “good” investors relatively few
– No effect on share prices of “bad” companies
– Little effect of, and cost to, being a “good” investor
• Investment returns similar to other investors
• Unless “good” investors prescient regarding poor
future economic performance of “bad” companies
• Growing “good investor” importance
– Increases relative share price of “good” versus “bad”
companies
• better eventual returns for early “good” investors
– Regardless of whether “bad” companies are bad
economic performers
© Kevin Davis
Almost/Slightly Efficient Markets
• If Many “good” investors who avoid “bad” cos.
– Lower share price relative to book value (& good cos.)
• If there is no “economic” basis for avoidance
– Investors in “bad” companies get better rate of return
– But bad companies have higher cost of capital
• If there is an “economic” basis
– eg “good” investors predict bad outcomes for bad cos.
– ESG investors may ultimately have better returns
– And bad companies have higher cost of capital
© Kevin Davis
“Good” Investing: Some questions
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Does it reduce investor returns?
What performance benchmarks should be used?
Does it help socially responsible companies?
Does it affect company behavior?
Do investment selection techniques matter?
Do portfolio characteristics differ?
Are clients of ESG fund managers different?
How should ESG fund managers be compensated?
Is “exit” or “voice” a more effective way of being “good”?
© Kevin Davis
Recent Research Findings
• 2008 Journal of Banking and Finance paper by
Renneboog, Horst and Zhang
– Reviews 16 papers on SRI mutual fund performance
• published between 1992 and 2008
• Funds from US, UK, Europe etc
– Comparisons of SRI and non-SRI fund performance
• Investment rates of return (adjusted for systematic
risk differences)
© Kevin Davis
Recent Research Findings
• Rarely is there a significance difference
– For UK and USA
– But perhaps SRI fund underperformance in
Continental Europe and Asia-Pacific
• Indication of bias towards small-cap stocks
• No differential (or good) market-timing ability
• Performance of SRI funds may improve with age
– More experience, or just “ahead of the pack”
© Kevin Davis
Recent Research Findings
• Maybe no difference in returns, but…
• “good” investing may lead to lower share prices
for “bad” companies
• “good” has a number of dimensions
• Galema, Plantinga, Scholtens ( JBF 2008)
– No difference between risk adjusted returns for
portfolios selected on good v bad SRI characteristics
• Characteristics obtained from KLD Research and
Analytics, US data for 92 -06
– SRI characteristic differences reflected in share
prices (market/book ratio)
© Kevin Davis
Recent Research Findings
• “The wages of sin is…” Romans 6:23
– Actually, higher returns, SIN STOCKS outperform
• Less “Sinvestors”, but many “Sinsumers”
– Low share demand but strong underlying economics
© Kevin Davis
Recent Research Findings
• Expect lower share prices, higher returns
• Hong & Kacperczyk (SSRN 2005) TAG stocks
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30 b.p per month return premium p.a. 1962-2003
Lower market/book ratio (17% lower)
Less held by institutions (but not mutual funds)
Less covered by sell-side analysts
• Investors conforming to social norms incur a cost
• TAG stocks face a higher cost of capital
© Kevin Davis
Recent Research Findings
• Little study of how to best be “good”
– Negative/positive screens, “best in breed” portfolios…
• Derwall et al (FAJ 2005)
– Environmentally “best in class” portfolio returned
12.2% p.a versus 8.9% for “worst in class”
– Significant differences after allowing for risk factors
– using Innovest ratings of firms for 1995-2003
• Kempf and Osthoff (EFM 2007)
– positive significant returns from portfolio constructed
as long 10% best SRI and short 10% worst SRI
– use KLD characteristics & best in class screens 92-04
© Kevin Davis
Doing “good”
• What role for shareholder activism by funds?
• Black (1998) “institutions achieve the effects on
firm performance that one might expect from this
level of effort – namely, not much”
• Karpoff (2001) – leads to changes in governance
structures but negligible effects on share values
and earnings
© Kevin Davis
Shareholder Activism
• Barber (2006)
– Calpers focus list has generated large wealth creation
gains
– Reflects shareholder activism focused on managerowner agency problem.
– Social activism problematic for pension funds
• Becht et al (2008)
– Clinical study of Hermes (BT Pension Scheme)
– activism via private unobservable interventions
– Exhibits return outperformance
© Kevin Davis
CSR and Corporate Performance
• Are “good” firms better stock market performers?
• Orlitzsky et al (2003) meta study
– CSR generally associated with better financial performance
– Two way causality (they can afford to)
– Benefits due to external reputation rather than internal efficiency
• Lougee and Wallace (2008)
– Measured CSR performance has declined – because of
emergence of more CSR issues
– Reducing CSR weaknesses has more effects on financial
performance than increasing strengths
– CSR implemented as a form of risk management
© Kevin Davis
A Postscript: It’s difficult to be “good”
• Did your fund invest in CDO’s ?
© Kevin Davis
Conclusion
• Evidence somewhat mixed, influenced by
historical emergence of “good” investing
– No clear evidence of underperformance
– Affects companies via share price impact
– The style of “good” investing may matter
• “Voice” (activism) rather than “exit” (investment
decisions) may have more influence upon
investment returns and corporate social
responsibility
– CSR aimed at external perceptions
© Kevin Davis