March 27, 2015

Sustainable Momentum Investing: Doing Well By Doing Good

Socially Responsible Investing (SRI), also known as Environmental, Social, and Governance (ESG) investing or Impact Investing, is the major application of ethical and social criteria, as well as financial considerations, in making investment decisions. SRI recognizes and incorporates societal needs and benefits in the selection and management of investment portfolios.

SRI has a "feel good" aspect to it, but investors also want to know if they are sacrificing potential returns by adhering to their social ideals. We will look to see if SRI makes sense economically, as well as socially and ethically, and, if it does, then how investors can use SRI for momentum-based investing.

Early History of SRI

SRI first dates back to the Quakers who, in their 1758 yearly meeting, prohibited members from participating in the slave trade. Their Friends Fiduciary investment service has existed since 1892 and continues to manage Quaker assets following SRI guidelines.

Another early adopter of SRI was John Wesley (1703-1791), one of the founders of the Methodist Church. Wesley’s sermon on “The Use of Money” outlined the basic tenets of social investing – do not harm others through your business practices and avoid industries which can harm the health of others. In the 1920s, the Methodist Church of Great Britain adopted this policy by investing in the UK stock market while avoiding companies involved with alcohol and gambling.

The first public offering of a socially-screened investment fund was in 1928 when an ecclesiastical group in Boston established the Pioneer Fund. In 1971, a Methodist group organized the PAX World Fund, which appealed to investors who wanted to be sure their profits were not coming from weapons production.  Two years later, SRI went mainstream when Dreyfus, a major mutual fund marketer, launched the Third Century Fund, which grouped together companies noted for their sensitivity to the environment and their local communities.

Social Change through SRI

In the 1980s, SRI became more widespread due to its negative screening of investments in South Africa. SRI practitioners were able to put pervasive pressure on the South African business community that eventually forced a group of businesses representing 75% of South African employers to draft a charter calling for the end of apartheid. Nelson Mandela himself remarked that the University of California's multi-billion dollar divestment was particularly significant in ending white minority rule in South Africa. .

SRI Performance

Although SRI has effectively used market forces to help bring about social change and has been emotionally rewarding to its participants, there has been a long-standing question of whether SRI performance has suffered due to the restricted opportunities available to SRI investors. Over the years, there have been many studies and meta-studies of SRI versus conventional investment performance. A number of studies from the 1990s and 2000s showed no statistical significance between the returns of socially responsible mutual funds and those of conventional funds. One objective survey and assessment of the subject that was the Royal Bank of Canada's 2012 report "Does Socially Responsible Investing Hurt Investment Returns?" The conclusion they reached, based on all the available evidence to date, was that investors had been no worse off with SRI investing than with conventional investing.

Evolution of SRI

In recent years, SRI evolved from exclusionary screening out of investments to include a more proactive approach toward Corporate Social Responsibility (CSR). CSR is a blend of both negative screening and positive selection in order to maximize financial return within a socially aligned investment strategy. Examples of negative screening factors are company involvements with gambling, alcohol, tobacco, weapons, under-age workers, animal testing, and damage to the environment. Examples of positive selection criteria are pollution control, community involvement, energy conservation, consumer protection, human rights, product safety, favorable employee working conditions, and renewable energy utilization. CSR oriented investment programs might also vote their proxies to advance ethical business practices, such as diversity, fair pay, and environmental protection.

CSR further evolved and expanded to include a broader set of Environmental, Social, and Governance (ESG) factors. Interestingly, ESG was soon seen to have practical benefits for the companies that employed these criteria, as well as for investors in those companies. Good citizenship has proven to be good for business.

Performance of ESG Companies

There are a number of reasons that can explain improvements in performance due to ESG. Corporate responsibility can create good relationships with governments and communities, as well as reduce the risks of onerous regulations and conflicts with advocacy groups. It can also influence how consumers perceive a brand and therefore serve a similar role to advertising. This can lead to higher sales and more loyal customers. In addition, corporate responsibility can have a positive influence on companies’ ability to attract and retain talented employees and maintain productive work forces.

According to DB Climate Change Advisors in their 2012 meta-analysis of more than 100 academic studies, “Sustainable Investing: Establishing Long-Term Values and Performance,” 100% of studies showed that companies with high ESG ratings exhibited financial outperformance and had a lower cost of capital, indicating they were less risky than companies with lower ESG ratings. Seeing all these benefits, the number of companies issuing sustainability reports has  skyrocketed. According to the 2013 KPMG Study of Corporate Responsibility Reporting, 93% of the world's 250 largest companies and 86% of the largest U.S. companies (by revenue) now publish annual sustainability reports.

However, what interests us most as investors is how investments in ESG oriented companies have performed relative to other companies. According to the DB Climate Change Advisors report, 89% of highly-rated ESG companies exhibited market-based outperformance and superior risk-adjusted stock returns.

A typical study by Eccles et al. (2011) compared the performance of 180 large U.S. firms by matching 90 high sustainability firms with 90 low sustainability firms. Beginning in 1993, $1 invested in the high sustainability portfolio would have grown to $22.60 by 2010, while the low sustainability portfolio grew to only $15.40.

Rapidly Growing Investor Interest

Companies doing well by doing good have not gone unnoticed by investors. The outperformance in the stocks of high sustainability firms has been attracting considerable investor interest. According to a 2015 survey by the Morgan Stanley Institute for Sustainable Investing, over 70% of active individual investors describe themselves as interested in sustainable investing, and nearly 2 in 3 believe sustainable investing will become more prevalent over the next 5 years.

Looking at recent growth, the global sustainable market has risen from $13.1 trillion at the start of 2012 to $21.4 trillion at the start of 2014, and from 21.5% to 30.2% of all professionally managed assets. Europe has the highest percentage of sustainable assets at 63.7%. But the U.S. has been the fastest growing region over this period and now has 30.8% of all global sustainable assets. The amount of funds invested in the U.S. using social criteria grew from $40 billion in 1984 to $625 billion in 1991 and to $1.5 trillion in 1999.

According to the most recent biennial "Report on U.S. Sustainable, Responsible, and Impact Investing Trends" by the Forum for Sustainable and Responsible Investing (US SIF Foundation), the number of ESG mutual funds in the U.S. was 456 at the start of 2014, up from 333 two years earlier. Assets in U.S. sustainable funds were $6.57 trillion at the start of 2014, up from $3.74 trillion at the start of 2012. This is a growth of 76% in just two years. Assets held in some form of sustainable investment now account for more than $1 out of every $6 under professional management, which is up from $1 out of every $9 in 2012. Investors realizing that ESG oriented funds, which in the past showed no disadvantage to conventional funds, have evolved into ESG funds that now offer superior investment performance when compared with conventional funds.

Dual Momentum with ESG

In my book and on my website I show how dual momentum (a combination of relative strength momentum and trend-following absolute momentum) can enhance and improve the performance of different kinds of investment portfolios, such as global equities, balanced stocks and bonds, and fixed income. We will see now what happens when we apply dual momentum to the world of sustainable investing.

I prefer to use low cost index ETFs as investment vehicles. However, that may not be the best approach with ESG funds. There are two reasons for this. First, the difference between a conventional index ETF's annual expense ratio and the average equity mutual fund's annual expense ratio of 1.08 is not nearly as great for sustainable index funds. For example, the  annual expense ratios for the Vanguard and iShares S&P 500 conventional index fund ETFs are .05 and .07, respectively. The annual expense ratios of the two KLD 400 Social Index ETFs, on the other hand, are much higher at .50. Based on expense ratios, sustainability index ETFs are at a decided disadvantage to their conventional index counterparts.

The second reason that sustainability index funds can be problematic is because of their short performance records. The earliest U.S. based SRI index is the Domini 400 Social Index, now known as the MSCI KLD 400 Social Index. It did not begin until May 1990. The oldest SRI index fund (Vanguard FTSE Social Index) was established only 15 years ago in May 2000.[1]

For these reasons, as well as the reason that active management might add some value in an area such as sustainability where more informed choices might be better than the mechanical rules, we will apply dual momentum to the oldest, actively managed, sustainable equities-based mutual funds.

Funds Used

The two impact equity funds that have track records longer than 25 years are Parnassus (PARNX)  started in May 1985, and Amana Income (AMANX) that began in July 1986.[2]

Looking at the details of these funds, Parnassus Fund has an annual expense ratio of 0.86. This fund screens out companies involved with alcohol, tobacco, gambling, nuclear power, weapons, and Sudan. Parnassus engages in shareholder activism and community investment. The fund has a strong ESG orientation with its mandate to invest in companies having sustainable competitive advantages and ethical business practices. Parnassus also prefers to buy out-of-favor stocks.

Besides incorporating ESG factors and exclusions for alcohol, tobacco, gambling, and pornography, Amana Income (AMANX) avoids companies with high debt-to-equity ratios and large receivables compared to total assets. Their emphasis on companies with stable earnings, high quality operations, and strong balance sheets free of excessive debt gives Amana a tilt toward quality, which is now recognized in academic circles as a beneficial risk premium factor.[3]

In addition, Amana prefers to hold shares in companies where management has a sizable stake, and the fund will sell shares in companies where insiders are selling. There is a large body of academic literature confirming that insiders are better informed and earn abnormal profits from their trades.[4]  Amana Income has an expense ratio of 1.14, plus .25 in 12b-1 marketing fees. However, institutional shares (AMINX) requiring a minimum investment of $100,000 are available with an expense ratio of 0.90 and no 12b-1 fees.

Here are performance figures through February 2015 for these two sustainability funds starting from July 1986 when performance data first became available for Amana Income. We also include the Vanguard 500 Index fund (VFINX), based on the S&P 500 index, as a benchmark. Vanguard 500 Index has an expense ratio of .17 [5]

          PARNX        AMANX            VFINEX
Annual Return 12.63  9.71 11.35
Std Deviation 21.71 12.02 15.32
Sharpe Ratio  0.39  0.48  0.47
Worst DD -47.98 -34.70 -50.97

We see that Parnassus has a higher return than the S&P 500 with around the same maximum drawdown. Amana Income has about the same Sharpe ratio as the market with a lower maximum drawdown. The lack of performance homogeneity among these funds is a good thing for relative strength momentum investing. More diversity in performance creates more opportunities for profit. So let us see what happens now when we apply dual momentum to these funds.

First though, I should mention a potential problem of using higher cost actively managed funds. The performance of actively managed funds may revert toward the mean of all funds and be overtaken by the performance of lower-cost index funds. However, this may not be such a problem here for two reasons.

First, we are not selecting actively managed funds based on superior past performance that might subsequently mean revert. We are simply using the sustainability funds that have the longest track records. Second, we can easily include a low-cost stock index fund in our dual momentum portfolio. Dual momentum is adaptable. If there is a falloff in performance of our actively managed funds, the relative strength component of dual momentum can automatically move us to a lower-cost index fund. This is why we can confidently use actively managed funds within a dual momentum portfolio framework.[6]

Performance Results

Below is the same performance we saw above but with the addition of a dual momentum portfolio made up of both sustainability funds, the Vanguard 500 index fund for the reason given above, and the Vanguard Total Bond fund (VBMFX) as a refuge for when absolute momentum takes us out of equities. The operating logic behind this model that we call ESG Momentum (ESGM) is the same as for our Global Equities Momentum (GEM) model and is fully disclosed in my book, Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk.

Annual Return 12.63 9.71 11.35 6.48 17.6
Std Deviation 21.71 12.02 15.32 3.9 13.93
Sharpe Ratio 0.39 0.48 0.47 0.69 0.92
Worst DD -47.98 -34.70 -50.97 -5.86 -22.73
Utilization % 36 13 28 23 100
Results are hypothetical, are NOT an indicator of future results and do NOT represent returns that any investor actually attained. This is not a recommendation to buy or sell any security. Please see our Disclaimer page for more information.

We see that the Sharpe ratio of our ESGM model portfolio was more than twice as high as the average Sharpe ratio of the four equity funds. The ESGM maximum drawdown was less than half as large.[7] By being in bonds at the right time, ESGM was able to bypass the full severity of bear market drawdowns.

ESGM was in our sustainability funds 78% of the time that it was in equities. So our mission was accomplished of being mostly in investments that contribute to advancements in social, environmental, and governance practices, while simultaneously giving us exceptional risk-adjusted returns by using dual momentum. Those wanting news and additional information on sustainability can visit GreenBiz, Social Funds, and US SIF.

[1] The two social responsibility ETFs, KLD and DSI, began in 2005 and 2006 respectively.
[2] PAX World Balanced began in August 1971 and CSIF Balanced Portfolio began in October 1982, but both funds have large bond allocations. 
[3] See Asness et al. (2013), "Quality Minus Junk.".
[4] For example, see Jeng et al. (2003) "Estimating the Returns to Insider Trading: A Performance Evaluation Perspective" or  Cohen, Malloy, and Pomorski (2012), "Decoding Insider Information".
[5] We could have used Vanguard's Admiral shares with an expense ratio of .05 or a low-cost S&P 500  ETF, but we wanted to be consistent with the retail shares we used for our socially responsible funds.
[6] There are many more ESG oriented funds, both index and actively managed, that one can choose.  The three used here were selected based on their longevity.
[7] If one uses the oldest no-load SRI bond fund, Parnassus Fixed Income (PRFIX), in place of Vanguard Total Bond from the inception of PRFIX in October 1992, the metrics improve to 17.31% for annual return, 13.97 for standard deviation, and 0.89 for Sharpe ratio. Maximum drawdown remains at -22.73%.