Is it “Bad” to be a “Good” Investor?

Is it “Bad” to be a “Good” Investor?

Kevin Davis

Commonwealth Bank Chair of Finance

Director, Melbourne Centre for Financial Studies

© Kevin Davis

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

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Almost/Slightly Efficient MarketsDon’t bother, if it really

was there, someone would have picked it up already

Share prices reflect available information to some degree

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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 out-performance

• Correctness may relate to fundamentals or to just identifying where the pack is going!

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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

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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

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“Good” Investing: Some questions

• 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”?

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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)

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• 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”

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• 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)

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• “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

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• Expect lower share prices, higher returns

• Hong & Kacperczyk (SSRN 2005) TAG stocks– 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

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• 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

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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

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Shareholder Activism

• Barber (2006)– Calpers focus list has generated large wealth creation

gains– Reflects shareholder activism focused on manager-

owner 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

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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

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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

Is it “Bad” to be a “Good” Investor?

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