Wages of sin bring higher returns

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We live in a material world. The ringing of the opening bell at the New York Stock Exchange is broadcast worldwide each weekday, while church bells largely fall on deaf ears. But the pecuniary and ecumenical will intersect briefly on Monday as the management of FaithShares takes the podium at the NYSE to kick off the session.

Their launch of the first religiously based exchange-traded funds is the latest development in an investment phenomenon. Broadly defined, a whopping $2,700bn, or more than one-10th of all US managed funds are now deployed according to socially responsible criteria of some kind, according to the Social Investment Forum. Socially responsible investing (SRI) can be far more sophisticated than starkly dividing companies that are naughty or nice.

For example, the leading index provider in the field, RiskMetrics, ranks companies on their environmental, labour and societal impact, doling out scores akin to credit ratings. Global warming baddie ExxonMobil gets a poor double C while fellow energy producer Chesapeake Energy scores BB for its more benign, natural gas focus. Retailer Walmart gets a triple C, even as labour-friendly Target gets a double B.

But some investors see things in black and white. Islamic funds, such as the Amana Growth Trust, eschew banks or purveyors of alcohol while the Ave Maria Catholic Values Fund bans healthcare concerns that promote contraception or the use embryonic stem cells.

Booze is a differentiator among Christian funds, with FaithShares’ Baptist fund having zero tolerance while its Lutheran ETF bans only spirits. Its Catholic fund approves of alcohol. And, although the battle for souls continues to rage, Islam has at least temporarily gained the upper hand in the battle for returns. Islamic funds have outperformed Christian ones recently, largely because of their distaste for financial stocks.

But morality does not come cheap. It is slightly more profitable to be amoral, but even more so to be immoral. Great returns from guns, booze, gambling and pornography are counter-intuitive since they are so heavily regulated, limiting new entrants. Academic studies, most recently by Yale University’s Frank Fabozzi and colleagues, are compelling. His study spanning 37 years and 21 national stock markets shows a total return for a “sin portfolio” of 19.02 per cent versus a market return of only 7.87 per cent. Thus, a $10,000 investment in sin stocks would have become $6.3m versus just $164,000 in standard equities.

Exploiting this trend and turning it into an impressive historic return is The Vice Fund. Manager Charles Norton says he benefits indirectly from others’ distaste for these sectors. “Therein lies the opportunity,” he says. “Whether or not a company makes you feel warm and fuzzy is not our concern.”

Of course many SRI funds outperform and deny they face any handicap.

“It’s another investment strategy and, like any strategy, it depends on the skill of the portfolio manager,” says Eric Frenald, a researcher at RiskMetrics.

But, as a group, Professor Fabozzi points out that restricting investment choices on non-economic grounds has a cost according to financial theory.

Market returns are finite, hence sin stocks’ good record comes at the expense of everything else, at the margin.

If it really affects performance though, this raises the question of whether fund managers’ fiduciary duty should override ethical concerns. Calpers, America’s largest public pension fund, acknowledged the conflict when it decided to eschew investments in some developing countries even if it cost up to three percentage points of performance in certain portfolios.

Individual investors face no such quandary as they can decide for themselves to possibly sacrifice returns for their values. But they must understand that refusing to buy a cigarette maker or defence contractor will actually deprive these industries of capital.

Mr Norton counters: “We’re of the opinion that you can make much more in the market and then donate to charity if you want. But mixing the two isn’t wise.”

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