The Hindu Business Line : Investing, SRI style

The socially responsible investing style is more to do with an individual's ethical values. In essence, it is an investment style that weaves philosophical issues into the portfolio construction process.

SOCIALLY responsible investing (SRI) has been an accepted concept in the US for sometime now. That such a concept is yet to be adopted by Indian investors may be to do with the quality of life here.

A sizable proportion of the population is below the poverty line. This lowers the cost of flouting social responsibility for the companies. Besides, the search costs for SRI-style investing is high, making it unattractive for investors.

In fact, SRI as a concept may not have figured in the media but for Rotary International, which is currently scouting for members who adopt SRI. This article looks at some issues relating to SRI-style investing and why it may be difficult to implement the concept in India.

Social responsibility investing: This involves selecting companies that also contribute to the welfare of society. Typically, this style of investing avoids companies that manufacture alcohol and tobacco-related products or activities that are highly polluting. Some even ignore companies that test their products on animals or employ child labour.

The SRI-style of investing is more to do with an individual's ethical values. In essence, it is an investment style that weaves philosophical issues into the portfolio construction process.

Will SRI be a popular investment style in India? That depends on whether this style of investing outperforms the non-SRI styles.

SRI vs non-SRI investing: There has been no consensus opinion in the US on whether socially responsible investing (SRI) outperforms the non-SRI style. Statman (2000) finds that SRI-style mutual funds marginally outperformed non-SRI style funds but such outperformance was not statistically significant.

In fact, Statman concludes that "... pooling investing power for something other than making money is no worse at making money than pooling it for money alone."

A 2004 Erasmus University Working Paper, however, finds significant alpha for a portfolio that uses environment rating as part of its active management strategy. Finally, a Stern School of Business Working Paper finds that mutual funds that followed a strict social responsibility screening performed well but so did a fund that had the weak screening practice. Importantly, the ones that followed moderate screening under performed.

These conclusions may, however, be comforting for the ethically inclined. After all, studies in this area have not found SRI-style significantly underperforming the non-SRI style despite the investment constraints. Yet, it is moot whether these conclusions will hold good in India.

Indian context: Corporate social performance is positively correlated to corporate financial performance (Orlitzky et. al). Behavioural finance literature, however, shows that investors suffer from cognitive biases.

This means that asset values need not be strongly related to corporate financial performance. Even if it were, SRI-style funds may not match the returns of the non-SRI style, let alone outperforming it.

The reason is this: Companies that adopt social responsibility will be typically large-cap stocks. Such stocks have significant analyst coverage. This means that the scope for outperforming the broad index is limited, unless the portfolio manager of an SRI-style fund successfully engages in market timing.

This argument is more overwhelming if one looks at the Domini Social Equity Fund, the largest socially and environmentally screened index fund in the US. This fund closely tracks the Domini 400 Social Index, which primarily constitutes large-cap US companies. If a US-based social fund is constructed with large-cap stocks, it is highly unlikely that a fund in India will be otherwise.

The reason is that flouting social responsibility in India has lower costs. It is, hence, more likely that large companies will adhere to the rules because they suffer high reputation risk than the smaller companies.

The case can be looked at from the non-SRI side as well. The neglected-firm effect is very strong in India. That is, stocks that are not well researched typically outperform the broad market. It is more likely that non-SRI funds will have a sizable proportion of such companies in their portfolio.

Of course, the SRI-non-SRI differential returns will be lower if more people adopt ethical values for their investment decisions. Mutual funds, for instance, can take active role and vote against socially responsible issues.

The Investment Responsibility Research Centre, for instance, states that 100 largest mutual funds in the US opposed social issue resolutions during the first half of 2004.

Such active participation by shareholders could eventually force smaller firms to also adopt social responsibility. But to arrive at such a scenario, we need to adopt SRI-style investment. And now is as good a time as any.

(Feedback can be sent to bvenky@thehindu.co.in)

References:

1. Barnett, Michael L., and Robert M. Salomon, "Porous, Pious, and Prosperous: The Curvilinear Relationship Between Social Responsibility and Financial Performanc,", NYU Stern School of Business Working Paper, November 2003.

2. Derwall, Jeroen, Nadja Gunster, Rob Bauer, and Kees Koedijk. "The Eco-Efficiency Premium Puzzle", Erasmus University Working Paper, May 2004.

3. Orlitzky, Marc, Frank L. Schmidt, and Sara L. Rynes, "Corporate social and financial performance: A meta-analysis." Organisation Studies, 24, 2003.

4. Statman, Meir, "Socially Responsible Mutual Funds," Financial Analysts Journal, May/June 2000.

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