Social investing is fraught with actual and potential challenges. Socially-responsible investors sometimes find that their social goals conflict with their targeted investment performance or portfolio diversification guidelines. Investors often rely upon biased social metric scores provided by third-party firms. All of this being the case, we think the rise of passive social investment vehicles could present the most significant stumbling block to social investors. Can investors hope to achieve a positive social impact through utilizing passive investments? We think not, for several reasons:
- Social investment scoring systems have a large cap bias.
- Correlations between social indices and broad market indices are high.
- The performance record of social indices is largely not good.
- Passive activism is an oxymoron.
Overlap between most social index stock holdings and the largest stocks in the major indices is high. One criticism of social scoring methods produced by Morningstar and MSCI is that they favor large companies. These large companies tend to have larger human resource and public relations departments that can manage social initiatives and champion social efforts. Similarly, larger corporations have more resources available to highlight their progress on social goals. Due to these facts, large companies are over-represented among the highest sustainability scores.
JAG assigns singular, numerical ESG scores to a large universe of common stocks using MSCI Environmental, Social, and Governmental ratings. We find that the average large cap stock (> $6 billion market cap) score is 0.61 (1 is the highest possible score), while the average small cap ESG score is 0.46. In a separate analysis, JAG also finds a material difference (nearly 2 points in a 10 point scale) in Environmental scores when we compare the top decile stocks by market cap and the bottom decile stocks by market cap. The result is a meaningful large cap bias to social scores, which leads to a noticeable tilt toward big companies within social indices. In effect, social investors who utilize passive investment vehicles are making a bet on large companies. Given the fact that it is more difficult and expensive to impact the behavior of very large corporations, we think passive social investments may work against many investors’ intentions to have a positive societal impact.
Not only do social indices skew large, they tend to hold large cap stocks roughly in proportion with weightings in the broad market indices. A September 2017 study by Balcilar, Demirer, and Gupta shows the correlation between the Dow Jones Sustainabilty indices and the Dow Jones conventional indices to be 0.987 in the Americas. Despite the close correlation, the authors conclude that diversification benefits, however de minimus, are possible by integrating social indices. We would observe that such a tight correlation reveals little difference (98.7% alignment) between the social indices and the broad markets. Another way to measure index alignment is “active share.” Active share figures indicate the percentage of holdings in a portfolio are NOT aligned with a benchmark. Close alignment generates a low active share score, whereas active shares above 80 are generally considered favorable for those attempting to achieve excess return relative to the indices. With that in mind, we note that compared to the S&P 500 Index, active shares of the MSCI Low Carbon Target ETF and Workplace Equality ETF are 52 and 62, respectively. As such, both ETF’s have a lot in common with the S&P 500. By failing to differentiate their holdings from broad market benchmarks, passively-oriented social investors may be diminishing their potential to make a positive impact.