One of the key questions that impact investors ask themselves routinely is about whether there's a cost that we should expect when we engage in impact investing. Whether it's in private markets, public markets, for primary issues, issues of public firms. And we've already seen, via our examination in the great expectations research, that there may or may not be costs, especially if we are trying to maximize return. Or seeking market level, or market rate returns. An early addition to the research arena in this area was research we did just after the turn of the century that has continued a tradition of examining social investing via the notion of a constraint, asking the question if we can strain out certain investments, is there a cost? Of course, one response to this notion of screening out is that, that is not impact investing. Impact investing is a positive activity, although we've argued that screening is a component, or a methodology, or a style of the impact investing. At the end of the day, because all allocations to your investments must, in percentage terms, sum to 100%, 100% whether you screen out or screen in, must represent the totality of your investment portfolio, there is a sense in which any screening out or any screening in involves compenstion in terms of some other investment. For example, if we decide to, out of $100, focused 75% of our portfolio on only clean tech organizations, either in private or public markets, we still have to think about how to complete our allocation. That is to say, focusing heavily on positive investments and impact must be, in some sense, almost surely a negative screen on some other investments. At least with respect to the allocations that would otherwise be optimal for us were we not to consider social responsible or ESG or impact considerations or impact notions. So we studied this just after the turn of the century in an article, a working paper that we published with my colleague Rob Stambaugh here at Wharton and David Levin, one of our excellent students, who was at the time working for Kofi Annan. We examined whether impact investments can outperform non-impact investments as a key central question. Again, according to academic finance and probably logic, in a diversified portfolio of investments like stocks, an impact constraint such as emphasizing, or overemphasizing if you like, with no judgement attached to it, such as we see in SRI or screening offending companies out of a portfolio, always has an expected cost unless the constraint does not bind. Our question in our research was what was the magnitude of that cost. At the end of the day, this research, building on the shoulders of giants like John Gerard, Harry Markowitz and others has the answer, it depends on circumstances. From our perspective in our laboratory, we ask what is social responsibility from the perspective of an investor interested in maximizing what's called the Sharpe ratio. The Sharpe ratio is the ratio of reward to risk of an investment allocation. Stocks, bonds, commodities, impact, non-impact, whatever your allocation might be, the Sharpe Ratio measures its expected or average or realized returns relative to its risk here conceptualized in the form of volatility and typically measured with standard deviation. It's called the Sharpe ratio not because it's pointy, but because Bill Sharpe, the 1990 Nobel Prize winning economist developed it in his early work on modern portfolio theory. This is what some call a quadratic investor because in economics, quadratic utility refers to the squaring of volatility or standard deviation into variance in the calculation. In our world, we wanted to examine those investments available to retail investors, so we focused on mutual funds. It allowed us to find the problem narrowly enough to provide an answer. And for our purposes, we focused on domestic diversified equity funds who are generally trying to beat the market. We allowed two considerations to be at play along with either being, quote, unquote, responsible or not or impact oriented or not. First, what manager skill opinion you might have. Do you believe in manager skill, active management or passive management? Are you someone who wants to beat the market or would you prefer to be passive and be the market? And how good any given academic model is. In other words, we tried to look at the idea of maximizing the Sharpe ratio or maximizing the reward to risk ratio using mutual funds that are domestically oriented. To do so, we construct portfolios, without the ability to short sell, include a number of models. A model that says we should only invest in the market portfolio. That was a concept made famous by Bill Sharpe and also Jack Bogle, the founder of Vanguard as well as others. Including those at Northern Trust and Melon Capital Management over the years. We'll use a value/growth and size investment style adjustment model. And also a more recent one that adds investment momentum. One of the key realizations, also by the way, developed at least in part by Bill Sharpe famously in the late 80s and particular in a 1992 article that he wrote was the idea that style very much matters for investment outcomes. For example, it turns out style may matter as much or more than a manager's ability to actually find investments that outperform. In particular, style and diversification across style is a key consideration in maximizing the benefit. Of course, as you might expect, style relates to impact. For example, it's very hard to be an investor in heavy industry or invest in very old industries and still maintain the same level of carbon footprint as you might have if you are only investing in clean tech and green tech or just technology in general. We took the advice of Wayne Silby, the founder of the Calvert Organization, and allowed varying allocations to social responsibility, under the idea that investors might not want to be purely impact oriented. Although today, they might have an ever more availability or ever more accessibility to social impact, historically it's been fairly challenging to be entirely oriented toward impact across all your investments. We then compare portfolios that try to maximize reward to risk characteristics with and without attention paid to impact considerations. We looked at a series of mutual fund focusing, again, directly on equities, requiring three years of history. We avoided funds with loads, upfront fees or exit fees. We looked at about 3,500 funds before conditions, and just under 1,000 After those conditions. We developed a list of 19 different screens. In other words, 19 dimensions of impact. And this concept of dimensions of impact, of course, relates fundamentally to how you might think about impact for you. For example, is a carbon footprint important to you? Is gender diversity on boards, important to you? Do you have a particular, Set of stakeholders that are important to you? What is your agenda? Are you thinking about the environment? Are you thinking about animals? Do you have an LGBT set of considerations? Are you thinking about the base of the pyramid? We developed 19 different screens, along which investment managers listed their impact activities. So what, from our perspective, that means, is that we can think about reward and risk, as part of what matters to you. Economists calling those preferences or utility, plus 19 other considerations or dimensions of consideration. Of course what that immediately gives rise to, again, which we've talked about earlier in this course, is the idea that what might be impact to you, might not be impact to me. And although there are generally developing definitions of impact, you certainly might have sensitivities to different ones in different ways, from someone who's sitting next to you. So we developed these notions from the literature. We talked to portfolio managers, impact and social responsible investors, ESG investors, we looked at prospectuses, and so on. At the end of the day, we identified, back around the turn of the century, a sample of about 106 single share class funds, from which 35 were identified as socially responsible. Now, we know very well, as we've also discussed earlier in the class, boy, there have been tremendous increase in the number and size of impact ESG orientation in investments. Again, a number that emerged just very recently, was that there might be as much as about $90 trillion globally. Which is just a huge number, represents almost doubling of the most recently available numbers. When we looked at the characteristics of retail mutual funds that were oriented towards impact or not, so-called social responsible or not social responsible, we actually found that expense ratios were higher for social responsible funds that were active. In some sense, the idea of being impact and orientation might be fundamentally defined as active. Because you might have to be actively involved in understanding, implementing non-financial considerations. Whether it's as simple as screening something out of your portfolio, which by the way, is not at all simple. Or doing in-depth due diligence on very pointed positively screened investments, that you would bring in, of course, without consideration. Or with the explicit screening out of other Investments that would otherwise be optimal for you on purely a financial basis. The expense ratio for non-socially responsible mutual funds, we found was 110 basis points over the time period studied, whereas socially responsible mutual funds were about 136. Generally speaking, we think that the active management fee schedule has declined in the years intervening since we wrote original research. Recently, I saw a number that said that actively-managed funds in the same universe, had expense ratios in total around 75. But again, we expect social responsible funds to have higher expense ratios. Turnover, or the proportion of portfolios that were traded in a given year, was significantly lower for socially responsible funds. In fact less than half the level of trading. In some sense reminiscent of the gestalt of long-term investing that is so often referenced in the impact world, otherwise known as patient capital. Total assets, these are nominal not real numbers, was just over half in the socially responsible fund sample as the non-socially responsible fund sample. And loads were greater when there were loads. When we examine style and performance of non-socially responsible mutual funds and socially responsible impact-oriented mutual funds, we found something that might have been surprising and informative, on both a performance and style basis. First, we found that socially responsible funds had greater general market exposures, although at the margin. They had what we now call betas, or exposures of around 0.89 to the US equity market. Whereas non-socially responsible funds had betas of around 0.83. And you'll see that on the table in front of you, under the heading market MKT. That means that they vary a little bit more with US equities across time and across states of the world. Ups and downs for example, the non-socially responsible mutual funds. On the other hand, they appear to be a little bit less growth-oriented as we see from what is called the HML column in the table. HML stands for High Minus Low. These are from the work of Eugene Fama and Ken French, highlighting a portfolio, or behaviors of investments that are exposed to value versus growth. HML stands for High Minus Low, a portfolio constructed from high book-to-market ratio firms, relative to low book-to-market ratio firms, have a value kind of style, as opposed to a more growth style. So a little bit in contravention to the accepted notion that it's hard to be impact in orientation and still be a value investor. What we are finding here, is that yes it's true, you appear to be more growth-oriented. That's what the negative coefficient describes. But you're less growth-oriented than non-socially responsible mutual funds. The column labeled SMB. That stands for Small Minus Big. And what we show in the table is the loading, or risk sensitivity, or the beta on the SMB factor. So technical discussion, but the basics of it are that when the spread on small stocks over large stocks, S stands for small, B stands for big, goes up, you expect to go up 20% of that, all else equal. In other words, if small stocks outperform big stocks in this definition, again, all else equal, by about 1%, then you would expect to be up by one-fifth of that. Or one-fifth of the 1%, 0.2, or what we know as 20 basis points. There's a greater small stock exposure, as you can see, for the impact-oriented funds than the non-impact oriented funds, with a ratio, or loading, or coefficient of 0.2, versus 0.164. And perhaps this is most telling. It looks like exposure to the style known as momentum, which is very popular in today's investment world, is greater for socially responsible funds. There appears to be more of a momentum, or trend component to the returns of socially responsible funds, than non SRI funds in the historical data set. When they are trying to beat the market, they are apparently exposed to trends. Which I think might be intuitive from at least one perspective. We can see the coefficient of 0.05 is about double the coefficient of 0.0278 for non-socially responsible funds, as we see here for socially responsible funds. In other words, socially responsible funds are about twice as sensitive to past trends and returns of their investments, or investments in the market. Here equities at large. Finally, perhaps one of the surprising elements that when this paper was issued, some of the press seems to have missed, was that holding all the other effects I just mentioned, constant The level of equity returns, value versus growth considerations, small stock performance, momentum, trends, and results, really a strong set of controls. Out performance here, which we call delta, is more positive for the SRI sample, the impact sample, socially responsible investing sample, than the non-socially responsible sample. Now to be technically accurate, the numbers in parentheses are measures of statistical significance, here they're very close to 0. Generally would associate statistical significance with a value above 2 in absolute value. But what you see here at 0.17 and 0.23 indicate that we can't reliably say any of these funds out performed the value of 0. In other words, there appears to be no statistical out performance in either mutual fund sample. However at the point estimate, the 0.0021 or the 0.0008, that's basis points per month, 21 basis points month versus 8 basis points per month. If we don't consider statistical significance, which of course we should never not consider. It looks like socially responsible mutual funds have a kind of tilt toward outperforming non-socially responsible mutual funds, at least in our data. The thing about it though is that that is not the job of the investor. Of course, the Employee Retirement and Income Securities Act, ERISA, makes a side-by-side comparison idea between an investment that is traditional, and one that is impact oriented. Traditionally, a fiduciary's fulfilling an obligation, if they differ in no way on a financial risk adjusted financial way, in other words if they have the same Sharpe ratio, or performance. If you then consider social impact considerations, or characteristics, but the job of the investor is to produce the best trade off. And so what we examine next was whether that trade off was reduced, did you have a reduction in the reward to risk ratio by imposing impact? Interestingly enough with respect to the funds that we have, in general SRI funds had higher Morningstar ratings than the markets in general. This is a piece from Morningstar, you can see this at Morningstar.com. It's an independent, publicly traded organization now, that has a history of doing many things, including rating mutual funds, including SRI funds. There's a greater proportion of four or five star, four stars, five stars are better, quote, unquote, historically, than one to three on a performance basis. Not on an impact basis, which might have surprised many. And then when we look at individual performance, we see a number of interesting outcomes. The results on mutual funds suggest that when we form the best portfolio from the very large universe I mentioned earlier with and without the impact constraint, along all those dimensions, 19 different dimensions, if what you are is an index investor, the constraint does not bind very tightly. On the table in front of you, we have nine categories. They vary first by models, whether you believe the model is perfect, whether you believe the model is mediocre, or you think the model is really fairly bad, those are three general categories. And then we allow investment manager's skill from low to high. The columns model is perfect, and manager skill is 0, is the model here in the table in front of you, called the capital asset pricing model. That would put all of your wealth in a passive market index. Now this is a bit of a technical discussion but the key thing you should understand is the results in the first column suggest that you should have historically put 44% of your wealth in the AHA fund. And 19% in the Citizen's Fund Core-Growth. These are all impact oriented mutual funds, the Domini fund and so on. If you did so, the correlation between your portfolio and a portfolio that didn't pay any attention whatsoever to social impact considerations, and just optimized reward and risk, would have been 98%. And the cost, in what economist call the certainty equivalent, would only be seven basis points. Now this is a very small amount, it's certainly relative to our other results, and some might gauge this as being small in general. The key takeaway is that if you are index investor, even a number of years ago, you would apparently not have paid much a cost in expectation. To be an impact investor in the funds with the waitings that you see on the page. However if you go from left to right, if you believe this so-called index model approach that the academic CAPM model tells us to follow. And that's, by the way, the model that many have recognized Bill Sharp as receiving his Nobel Prize for. If you think the model has errors or is not a good model, then it seems that you pay a greater cost. Why, why do you pay a greater cost? Because you associate things like style with investment, style and investment value growth in small cap and large cap considerations. If we move to a model which is often called the Fama French Model for these styles considerations, we see that the cost can be much, much higher. For example, in the table that you see on the screen, if we think that the model is perfect, and the style. In order words, the styles that I just mentioned, small versus large investments, value versus growth. And you don't believe in manager skill, your correlation would now drop to 84% with the unconstrained, non-impact portfolio. And you'd pay a 31 basis points, or almost a third of a percent in expected costs. As you go from left to right in the table, what's clear is that, as you allow greater skill on the part of managers to be under consideration. In other words, if you believe fund managers can beat the market, your costs can explode. For example, if you believe that the investment managers can generate tremendous value by beating the market, or beating the model, beating the style, in this case, in the third column you can see that might cost you 1.5%. As you go from left to right, as the model gets worse, costs are fairly flat. The style model being really very important at its outset. What really is dominating here is your belief in manager skill, or the ability to beat the market. On an aggregate basis, what we find is that the impact constraint investing in retail mutual funds does not bind very tightly for a typical equity mutual fund investor seeking the highest ratio of reward-to-risk. In addition, in the case of market index investors, the cost appears very low for traditional parameters. However the constraint has expected costs that might be meaningful to someone, when style matters, or you have the belief that fund managers have skill. Or that the traditional style models, that are very usual in the industry, have flaws. The thing is, in all of this, it's not a judgement, it's not a moral judgement or an investment judgement. In the sense that, underlying the analysis that we've done here, under great expectations, and as you should think about when you consider impact investing in the future, This is a normative question. Presumably, rational investors, if they quote unquote give up a third of a percent, or 1.5%, or seven basis points, only 7% of a percent if they're an index investor, so very low levels there. They're getting compensation by being impact oriented. They are getting compensation by investing in a way that is consistent with their values or consistent with their mission. These days, especially as the number and character of products has expanded so rapidly, especially in the last three years, again, as we saw earlier in the course, perhaps the cost of these constraints is going down. You'll have to watch this space to see what the next round of research suggests. But what we understand is that in particular the governance constraints are likely to be the most costly, and the environmental constraints the most costly, whereas other constraints may not be as binding. Again, ongoing research is rapidly evolving, addressing an update of all these concepts. And we hope to see ongoing incarnations over time. What is an absolute conclusion any case is that social responsibility impact investing has certainly captured the imagination of institutional and private investors alike. It has not only captured their minds, it's captured their hearts. It has a major footprint. Pension plans, endowments, and foundations are voting with their feet. They're investing in impact products. They're considering the ongoing impact agenda. On an aggregate basis, the SRI constraint, the ESG constraint does not bind that tightly for a typical optimal equity mutual fund investors seeking the highest ex ante reward-to-risk tradeoff. And presumably, as more products are developed, including those that are designed to hedge, we may expect that to go down. Although, of course, this is an empirical question. Without judgment, of course, fiduciary concerns and prudent diversification concerns are always, here, more than just an overlay. That concludes this section of our course. I hope I've conveyed some idea the vast range and significance of impact investing topic in today's investment and corporate world. Over the last half decades, socially oriented investing, impact investment by today's language, and ESG orientation has leapt from being an interesting investment niche to the mainstream world of capitalism. It's influencing most of the world's governments, most of the world's biggest companies, and an increasing number of institutional and individual investors. Thank you for your time, and here hoping you, too, can do well by doing good.
