Sustainable Security Analysis An analysis of the economic cost of investing in sustainable securities

This paper examines whether a portfolio of global securities selected only on the basis of their sustainable characteristics exhibit a lower return than the broad global security market and whether the performance can be explained by a sustainable factor. The results do appear to indicate that investments that use sustainable filters may not exhibit lower returns than portfolios built without the sustainable filter. The results do indicate that investors should however, also take into account other risk factors such as country, industry, size and book to market as well as the sustainability factor. 1. The Sustainable Investment issue Interest in investments selected for their ethical or sustainable characteristics has seen strong worldwide growth in recent years. The Social Investment Forum (SIF) reports that professionally managed sustainable assets have grown by 36% compared to a 22% rise in other managed assets from 1999 to 2001. One consequence of investing in ethical securities is that, if companies selected on their sustainable characteristics perform better than alternative choices, it would be beneficial to both the investors and the society as it encourages other firms to improve their ethical standards. Conversely, if the performance of such ethical investments is inferior, or costly to investors, then the benefit of such investments may not adequately cover such loss, and would in turn cause pressure for relaxation of standards of ethical behaviour by the corporate community. Historical research of the impact of adopting a sustainable strategy on investment performance has concentrated on the analysis of the returns of sustainable or ethical mutual funds performances with no clear result. There are several problems with the historical research: firstly, by default, the analysis usually has not controlled for mandate restrictions, secondly, the analysis looked at nominal return only in most instances, ie it did not consider causes of the return, and thirdly, the analysis was looking for value added, whereas it is reasonable to say that if investors found that sustainable investment criteria was unlikely to result in lower returns, then given the other benefits to society, the result would be acceptable. Our research has therefore controlled for portfolio construction issues, other causes of security performance than sustainability, and concentrated on determining if there was evidence of underperformance. 2. Previous analysis Past attempts have been made to examine the relationship between sustainable investing and financial return. The analysis can be divided into three distinct categories: Individual Companies, Portfolios and Theoretical Portfolio construction. Research at the company level typically has tried to identify particular ethical criteria that influence the individual performance of companies. Numerous studies have been done examining the link between the ethical behaviour of a corporate firm and its financial performances. Moskowitz (1972) ranked 67 selected firms in terms of his evaluation of their level of social responsibility, and reported higher than average stock returns for highly ranked firms. Alexander and Bucholtz (1978) found no significant relationship between social responsibility and risk adjusted return on securities using the firms listed in Moskowitz’s study. Other studies such as Cochran and Wood (1984) found a positive relationship between corporate social and financial performances. Verschoor (1998) found a significant relationship between strong management commitments to controls that emphasised ethical and socially responsible behaviour, and favourable corporate financial performance. Herrmans, Akathaporn and McInnes (1993) found UK ethical corporate firms had higher 1 Social Investment Forum is a US based national non-profit organization promoting the concept, practice and growth of socially responsible investing. (http://www.socialinvest.org/) 2 See Lewis and Mackenzie (2000)