Among the lively discussions that characterise the world of Socially Responsible Investment (SRI), the one on financial performance is a classic. In a recent study (1), we analysed the BNP Paribas Investment Partners (BNPP IP) Best-In-Class universe of European stocks. Our observations differ from other literature in highlighting a size effect that determines financial performance. In this article, we present a summary of these observations.
Economic and ecological crises: catalysts for the integration of ESG criteria within asset management
In a social and political context recently marked by economic and ecological crises, the Environmental, Social and Governance (ESG) externalities of firms have became more visible and Corporate Social Responsibility (CSR) has become a hot topic among researchers and practitioners. Although there is an ongoing debate about the definition of CSR, existing definitions all relate to actions in favour of stakeholders (pro-social actions) that are carried out by firms, but not required by law. This environment intensified the interest in SRI, which has been defined for a long time as investing on the basis of both extra-financial criteria and traditional financial criteria. Recently, the AFG/FIR2 proposed a new definition that favours the objectives of SRI over the process itself. Within this framework, the objectives of investors are to obtain financial and extra-financial added value.
Financial performance and extra-financial performance: a relationship that is increasingly understood
The financial performance of SRI funds and indices is still an active research subject. Studies have so faroffered varied conclusions. The mechanisms underlying these observations are increasingly understood. Thus it has been shown that the level of extra-financial performance (i.e. the quantity and quality of the pro-social actions) interacts with the value of the firms via their cost of capital: those companies with no CSR policies are perceived as being risky. It has also been shown that the level of extra-financial performance interacts with the value of the firms via the profits generated by their activities: there is important literature on pro-social actions motivated by the search for profit. A lower cost of capital and higher profits are reflected in a higher share price. Nevertheless, according to many studies, the performance of SRI funds is, on average, similar to that of traditional funds. This can be explained by the informational efficiency of financial markets and/or there being fewer diversification opportunities. Thus, if markets integrate over a short time-span all the information that has an impact on the value of the firm, it is not possible to capture the related revalorisation. Conversely, if markets are inefficient, it is possible to obtain abnormal returns by systematically buying shares of “responsible” firms before this characteristic is priced in by financial markets. In addition, ESG filters reduce both the investment universe and the diversification opportunities of SRI funds. According to the modern portfolio theory, these reductions penalise the performance of SRI funds while, simultaneously, diversification protects traditional funds from the impact of extreme negative events that can affect companies lacking CSR policies.
The Best-In-Class universe: a selection of the best companies according to their extra-financial performance
The aim of the SRI investment process at BNPP IP is to exclude from the investment universe those companies that do not respect fundamental principles (e.g. the UN Global Compact), or religious principles (e.g. the “sin stocks”). These exclusions are normative. With the remaining universe, BNPP IP’s SRI investment process seeks to privilege those companies that show the best ESG practices compared with their peers, hence the Best-In-Class (BIC) process. Selected companies are the “IN companies”; those excluded are the “OUT companies”. Does a portfolio of “IN companies” financially outperform a portfolio of “OUT companies”? To answer, we built a universe that contains all firms included in the MSCI Europe that the BNPP IP SRI process has recommended as being IN or OUT between 15 January 2008 and 15 June 2013. This universe comprises 576 firms. We used it to backtest the performance of various portfolios weighted by capitalisation (CW) and equally weighted (EW). We calculated absolute, relative and risk-adjusted performance. The risk-adjusted statistics give us a performance measurement that takes into account the differences between portfolios. We carried out the analyses across all sectors together; by sector; and then by excluding companies classified as OUT for normative reasons.
Our results are in line with those of other studies of the performance of SRI: it is possible to generate financial added value by systematically selecting the shares of “responsible” companies.However, our observations differ from other literature in highlighting the importance of the size of firms in the amount of performance generated. Hence during the studied period, the alphas of the CW portfolio of IN firms and of the CW portfolio of OUT firms are not significantly different from zero. However, when small firms have larger weights in portfolios, as in the EW portfolios, then the alpha for the EW portfolio of IN firms is significant and equal to 291 bps/year while the alpha for the EW portfolio of OUT firms is equal to -83 bps/year. So within the framework of active portfolio management benchmarked against cap-weighted indices, there is a compromise between capturing this financial added value and respecting a strict risk budget. We also note that, across all sectors, the BIC selection favours large capitalisations and seems to modify the exposures to the risk factors. Hence, the CW portfolio of IN firms has significant coefficients of 1.05 to the Market factors and -0.01 to the Fama-French SMB factor. The CW portfolio of OUT firms has significant coefficients of 0.87 to the Market factors and 0.03 to the SMB factor. The two portfolios also differ in their exposure to the Low Beta minus High Beta factor: the CW portfolio of IN firms has a significant coefficient of -0.11 while the CW portfolio of OUT firms has a significant coefficient of 0.27. Finally, in some sectors, the group of excluded companies generated alpha. This could be explained by the use of normative criteria or by the use of extra-financial criteria that have no financial value or that have not yet been priced in. From an operational viewpoint, these observations favour a reinforcement of the analysis of the extra-financial performance of medium and small capitalisation firms as well as a questioning of the choice by some investors to systematically exclude some sectors from their investment universe.
Vincent Lapointe is a recent PHD graduate from Aix-Marseille Université (Aix- Marseille School of Economics), CNRS & EHESS
(1) Lapointe, V. (2013), “Financial performance of socially responsible investment: does the size of firms in the portfolio matter?”, Working paper, Aix-Marseille Université and BNP Paribas Investment Partners.
(2) The Association Française de la Gestion financière represents and promotes the interests of the French asset management industry; the Forum pour l’Investissement Responsable represents and promotes the interests of the French socially responsible investment industry.