By Ron Robins

SRI (socially responsible investing) ratings′ firms, like everyone else, are always looking for the ‘Holy Grail′ in finding the winning ratings methodology that can predict the market performance of a stock or portfolio. At this juncture, no magic methodology has been found—at least that is public knowledge!

We do know that some SRI stock portfolios have outperformed conventional compositions, and that these findings are generally gained through hindsight. Sometimes they are also ‘back-tested,′ which means they take the present portfolio and determine how it would have fared had it existed in years past. But our question is, are there predictive methodologies available anywhere that come even close to foretelling an individuals stock′s, or portfolio′s, future stock market performance?

The following research from Canada provides some insight into one ‘possible′ predictive methodology for portfolios. Titled, The Impact of Ethical Rating on Canadian Security Performance: Portfolio Management and Corporate Governance Implications, by Klaus P. Fischer and Nabil Khoury (both of the University of Quebec), found that “… a portfolio of stocks with zero concerns [‘concerns′ defined by a ratings agency] outperforms portfolios comprising securities with one, two and three or more concerns… our research indicates that there is good reason for relying on the number of concern scores in screening securities for portfolio composition.” So here we have validation that SRI ratings can predict stock market behaviour when applied to stock portfolios with a differing number of ‘concerns′.

In, The wages of social responsibility, Meir Statman (Santa Clara University) and Denys Glushkov (Barclays Global Advisors) demonstrate that SRI screening provides superior returns to conventional investing—but with a proviso. Quoting from their study abstract, “We analyze returns during 1992-2007 of stocks rated on social responsibility by KLD and find that this tilt gave socially responsible investors a return advantage relative to conventional investors… ”

Continuing, “However, typical socially responsible investors also shun stocks of companies associated with tobacco, alcohol, gambling, firearms, military, and nuclear operations. We find that such shunning brought to socially responsible investors a return disadvantage relative to conventional investors. The return advantage of tilts toward stocks of companies with high social responsibility scores is largely offset by the return disadvantage that comes from the exclusion of stocks of ‘shunned′ companies. The return of the DS 400 Index of socially responsible companies was approximately equal to the return of the S&P 500 Index of conventional companies.”

Perhaps the most authoritative compilation of SRI/ESG (environmental, social and governance) research and its relationship to market performance was released in an October 2007 study, Demystifying Responsible Investment Performance under the aegis of the United Nations Environmental Program (UNEP) Finance Initiative. The reviewers overall conclusion: “Of the twenty studies reviewed, ten showed evidence of a positive relationship between ESG factors and portfolio performance, seven reported a neutral effect and three a negative association.”

These studies reviewed by UNEP show definite promise for SRI/ESG screening. But what is observed are performance relationships comparing portfolios employing SRI/ESG screening with those that do not. Thus, these studies do not answer our question of whether SRI ratings, whether applied to an individual company or to whole portfolios, have any predictive potential related to stock market outcomes. As statisticians say, ‘correlations do not prove causation.′

In summary, SRI ratings applied to stock portfolios foretelling their future collective stock market behaviour has shown some potential. However, the academic work of determining the effectiveness of an assigned ratings firms′ individual company rating to stock market outcomes has yet to be done. Complicating this issue is over what stretch of time does this tracking need to go on for? Should it be for five, ten or thirty years? Also, would the ratings methodology need to change over time? What may hold more promise is the ‘best of sector′ approach, where a particular company is deemed a higher ratings′ score than comparable companies in the same industry.

Generally, we are unlikely to ever find the ‘Holy Grail′ of a highly predictive ratings′ methodology. But whoever can find something even 60-80% successful over a longer-term will greatly brighten our world and likely put Warren Buffett′s investing success to shame!

March 13, 2009

© Ron Robins 2009