Wednesday, January 21, 2009

Liberal Investing -- Another Bad Deal

CalPERS, the nations largest government employee investment firm, stopped 'social screening' last August. The Sierra Club Stock Fund liquidated last month, after having "trailed the benchmark S&P 500 index by about 6 percent a year." Citizens Funds, another SRI firm, sold its assets early last year to Sentinal, with seven Citizens funds merging into five Sentinal funds. The record does not seem to be favoring green investors. Why?

The thesis of the green, socially responsible investing (SRI) community is that going green will allow you to feel better about your investments, make the world a better place while yielding better returns (implying no additional risk). The increased returns will come through companies led by enlightened individuals that have better long term performance. The PAX funds, the first SRI fund offerer (since 1971), has a typical mantra: "We believe these companies are better managed, more innovative and better positioned to deliver long-term performance than their less enlightened competitors." However, there is a problem with this thesis.

First some investing basics:
  1. Investing in the total market investing yields market risk and market return. This is self evident.


  2. Active managers all use a strategy to forecast a subset of stocks they think will beat the market, and avoid stocks they believe are losers. From IndexInvestor.com:
    Consistently successful active management (that is, active management that delivers higher after-tax risk adjusted returns than a comparable index fund) ultimately comes down to consistently successful forecasting.
  3. Active management does not work. In fact, the best almost anyone can do is to invest in an index fund and assume the market risk and return. See origins of the index fund. As studied by John Bogle, et al, about one-third of active managers beat market any given year. There are a few like Buffett that are the long term genius investors, and some people win the WSOP as well. Most of us are not that lucky. Most of us now understand that the active fund manager's advantage is eaten up by expenses and fees. Investing is essentially a constrained optimization problem where the goal is to maximize the risk adjusted net return. The only way to increase return is to take on additional risk.
Well the greens imply a better return without a commensurate increase is risk by picking better led, enlightened, better managed companies. They assert their scheme is better than the market, in the same way that value investors favor their investments, and growth investors favor theirs. The turn-around specialist has his day. Unfortunately, no one scheme is better than the market. This is also true for the 'liberal scheme'.

I personally wish they'd destroy every last tobacco seed. However, as long as cigarette companies are paying a huge dividend, there will be a strong market for them. By "screening" then narrowing investing choices, SRI funds either eschew companies with an above-market return or exclude a loser that others are dumping anyway, which gives them no market edge. The net result is an increase in constraints, and hence and increase in net risk, but no commensurate increase in return. Additionally, the social research adds a burden (cost) to the fund management that is not borne out by other active managers.

The latest research shows that SRI funds lag other funds one full percentage point per annum over the last ten years. Indeed, the two huge California pension funds, CalSTRS and CalPERS, left billions on the table by shifting to SRI.

SRI funds still have the 'feel good' factor going for them, and they can point to some shareholder activism victories as well. SRI can also claim victory in opening up mutual fund proxy voting.

If SRI makes you feel better, then go green and get happy. However, do so with eyes wide open. Limiting your investments to the SRI subset adds constraints, ups risk, and thus generally makes it tougher to beat the market return. Also, such constraints typically increase management costs, which further depresses return on investment relative to the market. As Carl Winfield observed in Business Week, "good intentions do not always translate into high profits."

Admittedly, it's not just SRI: The same can be said for all stock picking schemes. Oh, the false promise of increased risk adjusted return! If you feel like risking a wad in the market, then (unless you are Warren Buffet) buy an index fund. You can do a lot worse than the market return. Just ask anyone in the California pension system.

20 comments:

Geoffrey Britain said...

Pointing out that 'green' and 'socially responsible' funds on-average do not yield as high a return as 'market-neutral' funds... in no way obviates the moral imperatives that motivated their creation and subsequent investor participation.

Anyone who asserts that money invested in the market has no moral component is engaged in willful denial.

Anyone who imagines that 'doing the right thing' does not carry a 'cost' is simply naive.

Economically, 'doing the right thing' places one at an economic disadvantage with competitors who have no such scruples.

Bob in Los Angeles said...

Hi Geoffrey, thanks for the comment. I agree with everything that you say in a broader context.

My point in writing this article is to educate the consumer about the false promise of better returns going green. The article speaks for itself on that regard.

Do you imply that investing in the Vanguard S&P500 fund is doing the wrong thing, or operating without scruples?

If everyone knows that smoking is bad for the smoker and everyone around them and drives up the cost of health care which you and I subsidize, then why is it legal? I'd sure like to know the answer to that question.

Carl said...

I'm not sure I agree that money in the market has much of a moral component. Sure, there are some bad actors at the margins, but most actions of most corporations are orthogonal to morality.

Geoffrey Britain said...

Hi Bob,

They seemed like noteworthy points to make and it wasn't clear to me exactly where your position on them lay.

"Do you imply that investing in the Vanguard S&P500 fund is doing the wrong thing, or operating without scruples?"

Not at all, it's too broad an index and morality too tightly defined across such a broad spectrum is bound to paint with too broad a brush.

The proper venue for addressing the moral dimensions of such a wide swath of companies as Vangard's S&P 500 is political rather than economic.

But I would not invest in a company with which I had a moral objection.

"If everyone knows that smoking is bad for the smoker and everyone around them and drives up the cost of health care which you and I subsidize, then why is it legal?"

The answer is personal freedom because where do you draw the line of precisely what is and is not illegal?

That said, firstly, I don't agree that smoking is 'bad' for the smoker, at least not all smokers. So for them, it's a personal decision.

Many smokers never get lung cancer. Yet, my 78 yr old, bachelor uncle just passed away from it and he never touched ANY tobacco products...he was even a bit of a health nut.

I also dispute that, except in the most egregious of circumstances, it's much of a problem for those around smokers.

I think the sociological rise in cancers is much more related to the myriad of chemicals and increased exposure by the public to them. It seems more than coincidental that graphs of the historical rise in cancers and increased industrialization match each other so closely.

But even should I grant you that smoking is bad for everyone...where do you draw the line? What about alcohol, junk food, obesity, lack of exercise and the plethora of 'bad' lifestyle choices people make? We subsidize them too, shouldn't they be illegal?

And if we follow through with that logic and, accordingly we all must eat and live so as not to place a financial cost upon others, where lies personal freedom?

Where does it end? Shouldn't starches and desserts be controlled, for everyone's good? After all, we're subsidizing those choices. In that scenario, is not individual freedom, of necessity a casualty?

The great science fiction author Heinlein said it best, "I hold it to be the inalienable right of anybody to go to hell in his own way."

You may find Bob that the healthiest lifestyle is not necessarily the most fulfilling.

Those who take life too seriously clearly fail to understand that they're never going to get out of it alive...;-)

Personally, I'd rather live a shorter but richer life than a long, safe and, of necessity (I would argue) quite boring one because that's not living and isn't the point of life, living?

Appropo to 'living' might I suggest watching the old movie, "Zorba the Greek" and after you've absorbed Zorba's lesson... getting back to me on this?

Geoffrey Britain said...

Carl,

I agree that the motivation of most corporate actions is orthogonal (good word!) to morality but the consequences of those corporate decisions and actions are frequently moral. That is the primary reason why we have consumer laws.

If businessmen always placed financial decisions against the moral calculus of the golden rule...there would be no need for consumer laws.

And reportedly, there are no consumer laws in heaven;-)

But as we are not in heaven we shall just have to muddle along, eh?

OBloodyHell said...

> Anyone who asserts that money invested in the market has no moral component is engaged in willful denial.


"Money, not morality, is the principle commerce of civilized nations."

*Someone* appears to have seen a difference.

Do a search on the quoted phrase to see who was in "willful denial".

OBloodyHell said...

> "If everyone knows that smoking is bad for the smoker and everyone around them and drives up the cost of health care which you and I subsidize, then why is it legal?"

This is total bullshit. It was demonstrated a long time ago that the health care costs are counterbalanced by the shortened lifespans of the smokers, leading to greater returns in social security and life insurance.

OBloodyHell said...

> I think the sociological rise in cancers is much more related to the myriad of chemicals and increased exposure by the public to them. It seems more than coincidental that graphs of the historical rise in cancers and increased industrialization match each other so closely.

Geoffrey, it is just as likely to be age itself. Cancers are a mutation in the DNA. When people are living 20, 30, and 40 years longer (as much as 75% longer than previous, at a minimum for many) thanks to the stuff that used to kill them not doing so, perhaps it's automatic that the DNA error rate starts to climb.

Not claiming it's not "chemicals", but that's one of those cheap answers which need not have any connection to reality.

Geoffrey Britain said...

OBH,

Jefferson's view notwithstanding, I stand by my assertion. Which is not to say that I favor introducing morality as the sine qua non in nation's decision making.

I quite agree that age may instead be the determining or, a concurrent factor in the increased incidence in cancers. In fact, I almost mentioned it.

Statistically, it should be fairly simple to determine if the incidence in cancers pre-industrialization reflects present levels in the over 75 age group. Many people did live beyond 75 back then, it's percentages of pop. that have changed. Just time, money and assembling the data is all that's needed.

But it may be a moot point, as what is, is. We are not going back to pre-industralization and the economic costs of 'cleaning up' those chemicals, etc. is prohibitive.

Finding a 'cure' for cancer and eventual biological adaptations conferring greater immunity upon us may are likely to be the answer.

But if not, well, something is going to kill all of us, as none of us is ever going to get out of life alive;-)

Carl said...

GB:

But don't you prove too much: since there are consumer protection laws, what's the moral component to invement?

OBH:

A study confirming that smoking saves governments' money is here.

Bob in Los Angeles said...

I differ with Carl and OBH that smoking is a net positive on the welfare rolls. I am not ready to make that conclusion.

Why? Because Philip Morris did their study in Czech Republic, a country that does not even exist anymore. How was their system comparable to ours?

When someone does a study in the US of A, please let me know gentlemen. Thank you.

Carl said...

Bob:

Here's one. There's also a whole book about it.

Geoffrey Britain said...

"GB: But don't you prove too much: since there are consumer protection laws, what's the moral component to investment?"

Perhaps Carl but I don't see it if I do. It seems to me that just because there are consumer laws...it doesn't absolve businessmen of their moral responsibilities toward their fellow man. And of course laws are hardly perfect, frequently being a case of "locks are for honest people" so to speak.

That said, the ancient roman caution of 'let the buyer beware' always applies. For no set of laws can save the fool from their foolishness.

OBloodyHell said...

> Statistically, it should be fairly simple to determine if the incidence in cancers pre-industrialization reflects present levels in the over 75 age group. Many people did live beyond 75 back then, it's percentages of pop. that have changed. Just time, money and assembling the data is all that's needed.

Without digging into it too much, however, it's actually difficult to tell how good the older determinations as to CoD would be.

You'd practically have to exhume the bodies and do a chemical analysis of the remains. And that represents a bit stickier a problem -- even if you get permission, that might somehow skew the data pool in some unobvious manner.

> it doesn't absolve businessmen of their moral responsibilities toward their fellow man.

GB, part of the issue, I think, lies within the modern corporate system. Back when families owned most businesses, there was a family name and honor to be upheld. Among corporate executives, there is no honor to be upheld.

This ties to the "Problem of The Sausage Game":

...so here's what the sausage game is: You win yourself a market with a nice all-meat sausage, the best sausage you can make. People eat that sausage and they say 'mmm-hmmm!' So now you've established the product, right? Now you can afford to start slipping in a little sawdust. Add the sawdust by small enough increments and no one'll even notice. People will still say 'mmm-hmmm!', because people are creatures of habit. Of course, five or six increments down the road, you'll end up with a product that bears little or no resemblance to what you started with, but you'll get away with it, for a while, at least. Your market share will hold, your profit margin will increase, and everybody will think you're smart.
- Leonard Caust -

You can see how that all relates -- when it was a family business, you cared about what happened in the long term for the company -- your kids would inherit any problems you created.

Nowadays, there is no longer-term component to businesses. It's all about short-term profits.

What we need aren't more regulations, per se, but more long-term interest in businesses by corporate executives.

That may tie to changing the regs regarding corporate structure, but it isn't going to be solved by more Federal Regulations about how business itself is to be conducted or supervised by disinterested government representatives.

OBloodyHell said...

Hmmm. Maybe something like an insurance policy...?

When you become an executive, you get an insurance policy bought in your name, which gets paid into as long as you are an exec. At certain times -- 5 yrs, 10 yrs, etc -- if the company still exists, if they haven't had any lawsuits, etc.,etc. (I'm being soft on the definitions... you can see what I'm getting at) -- you will recieve a proportion of that back. If the company fails, if its stock drops more than x% for each year afterwards, the money is diverted to the shareholder's as dividends.

Just an idea.

Geoffrey Britain said...

OBH,

Interesting idea as incentives are always a viable method for motivating people. T. Roosevelt's "carrot and big stick" works as well with individuals as with nations.

"What we need aren't more regulations, per se, but more long-term interest in businesses by corporate executives."

I've thought about this a bit and my insight is that corporate indifference to consumer interests has to do with whom the owners are...

By that, I mean to point out that a privately owned or family business is always clear as to their need to please the customer. As you rightly pointed out, a private business' livelihood is utterly dependent upon public acceptance of their product or service.

Whereas in a publicly owned business, the corporate officers primary (some would say sole) responsibility is to the shareholders.

Short-term profitability becomes their 'god', as shareholders typically care only for profits.

And, when incentives like company stock options whose worth is determined by share-price are thrown into the mix...corporate officers concern for the consumer plummets accordingly.

Company management's focus becomes meeting wall street expectations. And typically, this results in the gradual lowering of the quality of the product or service in order to (temporarily) raise profitability.

Typically, the CEO's are sitting on each other's company boards and, as long as profitability is acceptable, they rubber stamp each CEO's proposals.

When 'morality' is considered inconsequential to business decisions it makes it just that much easier for corporate officers of public companies to put any 'irrelevant' moral considerations aside.

Carl said...

GB:

I don't mean to be indifferent to morals, but corporations have a responsibility to their shareholders. If an action is lawful, it would be an unusual case where morality would trump profit making. Building unsafe chemical plants in countries with lax environment laws would be one situation where I hope morality would prevail. Short of such circumstances, the fiduciary duty to shareholders should be most important.

Geoffrey Britain said...

Carl,

I did not & do not mean to imply that you are indifferent to morality. Such could not be the case given the consistent content of this blog.

But you repeat my point. "If an action is lawful, it would be an unusual case where morality would trump profit making. Building unsafe chemical plants in countries with lax environment laws would be one situation where I hope morality would prevail. Short of such circumstances, the fiduciary duty to shareholders should be most important."

But why should morality prevail in the circumstance you cite? Because it's beyond the pale?

Perhaps, but where do you draw the line? Only dangerous products? Only physically dangerous products? What about liberal cultural 'products' like movies that gradually desensitize society in a clearly unhealthy way?

So, as long as a corporation doesn't harm anyone... anything goes because there is no right and wrong when it comes to the acquisition of wealth?

These are the resultant societal consequences of the suppression of moral considerations in business when publicly owned business are considered.

Carl said...

By the way Bob, the Czech Republic still exists--and you haven't showed why that study is invalid as applied to the United States, much less dismiss the other US-focused studies.

Carl said...

GB:

Physical harm yes. Unknown, and possibly non-existant, social harm, no. One is not forced to go to Hollywood movies (and indeed I do not). The social harms of which you speak are a matter of taste, not morals.