Socially responsible investing is de rigeur. The well-heeled have always wanted to make their money multiply; now they want to make the world a better place while doing it. Money-management firms are offering new products purporting to do just that. Investors can put their money in a variety of specially designed funds that don’t buy financial assets from companies engaging in purportedly irresponsible business, and are told that the returns on their capital will be unaffected.
Take BlackRock, the humongous asset-management firm. In the wake of the Parkland shooting, and in response to political pressure, it rolled out new funds that wouldn’t invest money in gun manufacturers. Or take Just Capital, a nonprofit that ranks companies on how ethically they behave. Already, Goldman Sachs has created an exchange-traded fund that tracks Just Capital’s rankings and invests money accordingly. There is demand for these products that financial firms are meeting.
The strategy is easily pitched to the rich and socially conscious: Your returns will stay the same, but you won’t be inadvertently financing companies that do evil things. There are plenty of jokes to be made here about upper-middle-class Boomer liberalism, but in fact anyone of any persuasion can be a socially conscious investor (provided the money): There are funds that exclude companies involved in fossil fuels, abortion, tobacco, or weapons manufacturing, catering to people concerned about climate change, religious ethics, public health, and pacifism. Another form takes the name ESG investing, for environmental, social, and governance, and evaluates companies’ performance along those dimensions.
If the bargain sounds too good to be true — perform as well as the average investor, save the world in the process — that’s because it is, argues investor Cliff Asness. Asness, the cofounder of hedge fund AQR Capital Management, proceeds from an intuitively obvious principle: “If two investors approach an asset manager, one who says ‘just maximize my return for the risk taken’ and the other who says ‘do that but subject to the following constraints,’ it is simply false and irresponsible for the asset manager to assert that the second investor should expect to do as well as the first.” Since socially responsible investing and its ESG subset often imposes relevant constraints on the asset manager — they can’t invest in this or that allegedly sinful company — one should expect the socially responsible funds to underperform compared with their unconstrained counterparts.
But what’s interesting about Asness’s argument is this: If the socially responsible investor is to accomplish her goal of making the world a better place, she must expect lower returns relative to investors who are indifferent as to where their money goes. In essence, Asness argues, this type of investing must be less efficient (in terms of expected returns) if it is to work.
Suppose gun manufacturer Smith & Wesson issues equity, and a group of socially conscious investors refuses to buy it. Their goal is to make it more difficult for Smith & Wesson to do business. Put another way, they want to make it more expensive for Smith & Wesson to raise capital. Asness points out that someone still has to own the equity Smith & Wesson just issued; “the market still has to clear.” So “the group without such qualms” as our gun-controlling investors — the rest of the market — must “own more than they otherwise would” of Smith & Wesson’s equity. But “how does a market get anyone, perhaps particularly a sinner, to own more of something? Well it pays them! In this case through a higher expected return on the segment in question.”
In other words, by pushing the price of sinful stocks down, the socially conscious investors are ensuring that the indifferent investors who buy that equity can expect higher returns on it. Asness says this is a built-in feature of socially responsible investing. “If the virtuous are not raising the cost of capital to sinful projects, what are they doing? How are they actually affecting the world as they wish to?” But if they are raising the cost of capital to “sinful” businesses, that is equivalent to raising the expected returns on capital for the people who are financing them.
If Asness is right, then socially responsible investors should expect lower returns than their indifferent counterparts if they are to secure a material change in the world. Of course, maybe the people putting their money in ESG funds are doing it because they were told their returns would be unaffected. If Asness is right, they will have to choose between the satisfaction of changing the world and the satisfaction of making money. Quite the dilemma.