21 December 2020.

While there is a view that in order to achieve positive investment ‘alpha’ or superior returns, the astute investor must compromise, at times, on ethics – the academic evidence may surprise you.

We draw on studies from The Responsible Investment Association of Australasia, the Department of Finance and Centre for Financial Research at The University of Cologne and The London Business School. Adding to an increasing body of evidence, these studies demonstrate that not only have ethical funds proven to break even with mainstream funds, they have outperformed their mainstream counterparts.

Could this be a judicious path to achieving positive investment alpha?

Alpha explained

Alpha is an investment term that describes the performance of a portfolio relative to its benchmark and can be positive or negative. It is the value that a portfolio manager either adds or subtracts from a fund’s return. For example, an alpha of zero indicates that the portfolio or fund is tracking exactly in line with the benchmark – having not added or lost additional value compared to the market.¹ Positive alpha refers to outperformance of the market, usually referring to ‘excess return’ or ‘abnormal rate of return.’

Misconceptions about ethical investment and positive alpha

There is an argument that because ethical investment requires screening, this reduces investment choice and diversification which may lead to lower than benchmark returns, or negative alpha.

According to U Ethical ethics and impact manager Désirée Lucchese this screening is critical not just from an ethics point of view but a risk management and performance one.

“Companies that do not consider their ethical imperative tend to be more subject to reputational risk which directly impacts share price; a contributor to negative returns or alpha.

“For example, at U Ethical we undertake a series of screens and ESG factor integration, meaning our investable universe tends to be high quality and low volatility.

“Furthermore, positive alpha tends to be best achieved by companies with strong governance and forward looking, future-proofed strategies.

“It makes sense really: harmful or objectionable corporate behaviours lead to negative consequences, in turn damaging share prices with greater exposure to litigation risk, reputation damage and decreased access to capital,” she said.

The academic evidence speaks for itself

Outside of the ethical considerations and longer-term future performance considerations, ethical funds are meeting, and even proving to outperform, mainstream funds at the basic level.

Drawing results from studies, including Alex Edmans’ ‘The link between job satisfaction and firm value, with implications for corporate social responsibility’, and Alexander Kempf and Peer Osthoff’s ‘The effect of socially responsible investing on portfolio performance’, and others, the table below outlines examples of long-only ethical strategies that have proven to generate positive alpha.

These analyses over various time periods use different criteria to define which companies are more (or less) ethical and their history of alpha, per year.

*past performance is not indicative of future performance

Adding to this body of evidence, this year the Responsible Investment Association of Australasia (RIAA) released its landmark annual study, the Responsible Investment Benchmark Report Australia 2020.³

The study revealed that companies which looked after their employees, minimised their impact on the environment, had good governance and addressed human rights across supply chains were more likely to deliver superior financial returns to investors, generating positive alpha.

The evidence is now clearer than ever – RIAA’s Benchmark Report evidenced that many Australian and multi-sector responsible investment funds outperformed mainstream funds over 1, 3, 5 and 10 year time horizons. This outperformance continued despite major market disruptions brought on by COVID-19 – which has been the most substantial test for responsible investment to date.

Lucchese believes that “alongside an increased yearning for ethics in investment, we are also seeing a strong correlation with positive investment alpha.”

“A growing body of evidence is showing ESG funds’ track record with performance, and whilst positive alpha-seeking requires a good dose of skills, it can be achieved,” she said.

References:

¹https://www.investopedia.com/t...

²The table presents the results of the following analyses: J. Derwall, N. Guenster, R. Bauer and K. Koedijk, “The eco-efficiency premium puzzle,” Financial Analysts Journal, vol. 61, no. 2, pp. 51-63, 2005; A. Kempf and P. Osthoff, “The effect of socially responsible investing on portfolio performance,” CFR Working Paper, no. 06-10, 2007; A. Edmans, “The link between job satisfaction and firm value, with implications for corporate social responsibility,” Academy of Management Perspectives, November 2012; P. Gompers, J. Ishii and A. Metrick, “Corporate governance and equity prices,” Quarterly Journal of Economics, vol. 118, no. 1, pp. 107-155, 2003; and L. Bebchuk, A. Cohen and A. Ferrell, “What matters in corporate governance?,” The Review of Financial Studies, vol. 22, no. 2, pp. 783-827, 2008 as featured in P1 Investment Management: https://p1-im.co.uk/research-a...

³https://responsibleinvestment....