Is it “Bad” to be a “Good” Investor?

1. Is it “Bad” to be a “Good” Investor? Kevin Davis Commonwealth Bank Chair of Finance Director, Melbourne Centre for Financial Studies

2. Overview and Outline Objective: outline and interpret recent evidence on implications of SRI/ESG (“Good”) Investing • Finance 101 – making sense of the evidence • What are the questions? • The evidence • do “good” investors pay a price? • what influence do good investors have? • Do “good” companies do good well? • A postscript: difficulties in being a “good” investor in a complex financial world

3. Almost/Slightly Efficient Markets Don’t bother, if it really was there, someone would have picked it up already Share prices reflect available information to some degree

4. Almost/Slightly Efficient Markets • Implications • It is unexpected news/ changed opinions which cause prices to change unexpectedly • Such as announcement of an unanticipated penalty scheme for emissions • But not commencement of a widely anticipated penalty scheme • Share price of those likely to be adversely affected will have previously fallen • Being “ahead of the pack” (and correct) generates out-performance • Correctness may relate to fundamentals or to just identifying where the pack is going!

5. Almost/Slightly Efficient Markets • If “good” investors relatively few • No effect on share prices of “bad” companies • Little effect of, and cost to, being a “good” investor • Investment returns similar to other investors • Unless “good” investors prescient regarding poor future economic performance of “bad” companies • Growing “good investor” importance • Increases relative share price of “good” versus “bad” companies • better eventual returns for early “good” investors • Regardless of whether “bad” companies are bad economic performers

6. Almost/Slightly Efficient Markets • If Many “good” investors who avoid “bad” cos. • Lower share price relative to book value (& good cos.) • If there is no “economic” basis for avoidance • Investors in “bad” companies get better rate of return • But bad companies have higher cost of capital • If there is an “economic” basis • eg “good” investors predict bad outcomes for bad cos. • ESG investors may ultimately have better returns • And bad companies have higher cost of capital

7. “Good” Investing: Some questions • Does it reduce investor returns? • What performance benchmarks should be used? • Does it help socially responsible companies? • Does it affect company behavior? • Do investment selection techniques matter? • Do portfolio characteristics differ? • Are clients of ESG fund managers different? • How should ESG fund managers be compensated? • Is “exit” or “voice” a more effective way of being “good”?

8. Recent Research Findings • 2008 Journal of Banking and Finance paperbyRenneboog, Horst and Zhang • Reviews 16 papers on SRI mutual fund performance • published between 1992 and 2008 • Funds from US, UK, Europe etc • Comparisons of SRI and non-SRI fund performance • Investment rates of return (adjusted for systematic risk differences)

9. Recent Research Findings • Rarely is there a significance difference • For UK and USA • But perhaps SRI fund underperformance in Continental Europe and Asia-Pacific • Indication of bias towards small-cap stocks • No differential (or good) market-timing ability • Performance of SRI funds may improve with age • More experience, or just “ahead of the pack”

10. Recent Research Findings • Maybe no difference in returns, but… • “good” investing may lead to lower share prices for “bad” companies • “good” has a number of dimensions • Galema, Plantinga, Scholtens ( JBF 2008) • No difference between risk adjusted returns for portfolios selected on good v bad SRI characteristics • Characteristics obtained from KLD Research and Analytics, US data for 92 -06 • SRI characteristic differences reflected in share prices (market/book ratio)

11. Recent Research Findings • “The wages of sin is…” Romans 6:23 • Actually, higher returns, SIN STOCKS outperform • Less “Sinvestors”, but many “Sinsumers” • Low share demand but strong underlying economics

12. Recent Research Findings • Expect lower share prices, higher returns • Hong & Kacperczyk (SSRN 2005) TAG stocks • 30 b.p per month return premium p.a. 1962-2003 • Lower market/book ratio (17% lower) • Less held by institutions (but not mutual funds) • Less covered by sell-side analysts • Investors conforming to social norms incur a cost • TAG stocks face a higher cost of capital

13. Recent Research Findings • Little study of how to best be “good” • Negative/positive screens, “best in breed” portfolios… • Derwall et al (FAJ 2005) • Environmentally “best in class” portfolio returned 12.2% p.a versus 8.9% for “worst in class” • Significant differences after allowing for risk factors • using Innovest ratings of firms for 1995-2003 • Kempf and Osthoff (EFM 2007) • positive significant returns from portfolio constructed as long 10% best SRI and short 10% worst SRI • use KLD characteristics & best in class screens 92-04

14. Doing “good” • What role for shareholder activism by funds? • Black (1998) “institutions achieve the effects on firm performance that one might expect from this level of effort – namely, not much” • Karpoff (2001) – leads to changes in governance structures but negligible effects on share values and earnings

15. Shareholder Activism • Barber (2006) • Calpers focus list has generated large wealth creation gains • Reflects shareholder activism focused on manager-owner agency problem. • Social activism problematic for pension funds • Becht et al (2008) • Clinical study of Hermes (BT Pension Scheme) • activism via private unobservable interventions • Exhibits return outperformance

16. CSR and Corporate Performance • Are “good” firms better stock market performers? • Orlitzsky et al (2003) meta study • CSR generally associated with better financial performance • Two way causality (they can afford to) • Benefits due to external reputation rather than internal efficiency • Lougee and Wallace (2008) • Measured CSR performance has declined – because of emergence of more CSR issues • Reducing CSR weaknesses has more effects on financial performance than increasing strengths • CSR implemented as a form of risk management

17. A Postscript: It’s difficult to be “good” • Did your fund invest in CDO’s ?

18. Conclusion • Evidence somewhat mixed, influenced by historical emergence of “good” investing • No clear evidence of underperformance • Affects companies via share price impact • The style of “good” investing may matter • “Voice” (activism) rather than “exit” (investment decisions) may have more influence upon investment returns and corporate social responsibility • CSR aimed at external perceptions