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:
- Investing in the total market investing yields market risk and market return. This is self evident.
- 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.
- 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.
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.