I want to thank Diana and the Hudson Institute for inviting me to participate in this important event.
Earlier this morning Diana brilliantly dissected the troubling pattern of underperformance among public pension plans, focusing in particular on the under-funding of these plans and general mismanagement. I'm going to turn the discussion in a slightly different direction, examining the ideological factors that have infected public and union pension funds.
State and local government pension funds and union pension funds collectively hold many trillions of dollars in assets. The vast majority are defined-benefit plans whose main goal is to provide a specific level of retirement benefits.
SRI proponents divide the investment world into ideological camps-there are so-called "bad" corporations that are to be avoided for what they produce or how they purportedly operate--entrepreneurial companies that prouded luxury goods for affluent consumers.
Until the early 1990s, the management of these funds was almost exclusively left in the hands of professional managers with little interference from politicians or union leaders who technically oversaw them. Few funds incorporated social criteria. Although there were no formal legal constraints, investing using social screens risked violating accepted standards of fiduciary responsibility.
Today, the situation is quite different. Almost all union pension funds are interrelated through a web of connections that tie trade organization, like the Council of Institutional Investors to social investment NGOs, like the Investor Responsibility Research Center. As a result, many if not most, public and union pension funds now employ social and environmental screens to guide their investments.
What is SRI--so-called socially responsible investments?
Social screening has its origins in the beliefs of Colonial-era Quakers, who withdrew their business from companies involved in alcohol, tobacco or gambling for encouraging "sinful" behavior. These notions remain the backbone of most "sin screens" even today. Public pressure to incorporate some social factors, including using funds to target economically depressed areas, arose during the late 1970s and intensified in the 1980s. The catalyzing event for the SRI movement was the boycott of apartheid South Africa, which tapped into the sentiments of newly affluent baby boomers sympathetic to an anti-establishment anti-corporate ideology.
Although there is some disagreement among social investment professionals, firms engaged in arms manufacturing, nuclear energy, tobacco and alcohol production, animal testing, and those companies deemed to contribute to global warming or engaged in genetic modification in agriculture are generally considered unacceptable-the stocks of these companies are completely shunned.
Stocks of public companies deemed to have poor records on these issues or in labor, environmental, or women's and gay rights policies are negatively screened out along with those corporations involved in heavy manufacturing, basic materials, and natural resources, which are marked as environmentally "messy".
In its broadest application, SRI proponents divide the investment world into ideological camps-there are so-called "bad" corporations that are to be avoided for what they produce or how they purportedly operate--entrepreneurial companies that prouded luxury goods for affluent consumers.
Then there are the "good" companies. In the early days of the social investment movement, in the late 1980s and early 1990s, the SRI heroes were such companies as Ben & Jerry's, Patagonia, and The Body Shop cosmetic company.
Over time, social investors also evolved what they called "positive social screens" to judge which mainstream companies engaged in so-called socially progressive reforms. They looked at such things as whether a company had a diverse board; how aggressively it promoted women and gays, and treated union workers; did it embrace so-called sustainability, including climate change theology.
Over the past 15 years, driven by the "pig in the python"--the demographic trend of aging baby boomers, like me, who came of age in the 1960s, social investing has emerged as a genuine phenomenon, with billions of dollars now invested in stocks using social screens. These SRI stock holdings are also used as wedges to promote highly politicized corporate resolutions of the kind Diana highlighted in her paper.
Its proponents made an alluring promise: "You can make money [loads of it in fact] and save the world; Buy Ben & Jerry's Brazil nut ice cream and get social justice for free." That promise has turned social investment advocates into media stars--the liberal press loves social investing--just read Gretchen Morgenson in the New York Times each Sunday.
Well, the reality has fallen a bit short of the promises. What has happened to the nest eggs of investors, including union workers, who have entrusted their pensions to these schemes?
That question reminds me of the observation of one of my heroes, Mark Twain, when asked about the key to success. "The secret to success is honesty and fair dealing," he said. "If you can fake those, you've got it made."
The fact is . . . social investing proponents have been peddling what amounts to the false promise of a free lunch for years now and those suffering the most are the most vulnerable-workers and idealists who believe they can promote ideological causes with their investments and earn superior returns.
For illustration, let's go back in time to January 2000. You manage a union pension fund that's decided to "do well by doing good." It has bowed to advocacy groups and agreed to invest its endowment in only so-called "good" companies--corporations that pass ideological litmus tests on the environment (no nuclear plants), corporate governance (independent boards), diversity (gay rights), and the like.
What companies do you invest in following the recommendations of these socially responsible investment groups? Well, Enron has independent directors. Krispy Kreme gives tons of money to charity. Cendant is renowned for its diversity. HealthSouth is actively involved in communities. Check, check, check, check.
The list goes on: Tyco, Adelphia, WorldCom, Rite Aid, Arthur Andersen, Qwest, Global Crossing, Martha Stewart, Bristol-Myers-Squibb, Lucent, Kmart.
Of course we know what happened. Every one of those companies-each one celebrated by social investors as "socially responsible" stars--flamed out or are worth a fraction of what they once sold for, victims of self-inflicted ethical wounds. The big losers were credulous pension funds, religious groups and liberal investors who put their hearts where their heads should have been.
A year and a half ago, in January 2007 I was approached by Bill Gates and asked for my advice on where the Bill and Melinda Gates Foundation should invest its $35 billion endowment. A few weeks before, the Los Angeles Times had run a series accusing the foundation of reaping "vast financial gains" from corporations with "environmental lapses, employment discrimination, disregard for worker rights, or unethical practices" that "contravene its good works."
The Times called it "blind-eye investing." It openly questioned why the Gates Foundation did not use social screens, as so many union pension funds had adopted.
After being contacted by Mr. Gates, I checked how the blogosphere was treating the story. There were literally hundreds of articles and entries, almost universally disparaging of the foundation. Words like "appalling" and "giving with one hand, taking with the other" ricocheted through the Internet and onto the opinion pages of dozens of newspapers around the world. At a minimum, critics said, Mr. Gates should avoid companies that counteract its stated mission. What should Bill do?
Social investors claim that the Gates Foundation is an 800-pound philanthropic gorilla that could change the world by adopting mission investing––the same challenge made to union and public pension funds. Only the realities of capital markets and the stark truth about social investing interfere with that equation.
U.S. stocks have an aggregate capitalization of $16 trillion. With all due respect to even the Gates Foundation's billions, or the billions of dollars in large union and public pensions, these funds, spread over many hundreds of stocks, have no effect on the market value of any single stock. Negative social screens to rid portfolios of "sin" stocks accomplish nothing in terms of their impact on the targeted firm, as long as the marginal investor is available to purchase the stock.
Selling a so-called "bad" company would have no more impact than scooping a thimble full of water out of the deep end of the pool; it goes back in the shallow end when the person on the other side of that transaction buys it.
The social investing community also suffers from the hubris that it can separate the good guys from the bad guys. The Times report mentioned that half of the children attending a high school in South Africa suffer from asthma and other respiratory disorders that the Gates Foundation is committed to eradicating. It noted that a nearby refinery that spews out pollutants is owned in part by a foundation-held company, BP.
The dark secret of "social investing" is that it is neither art nor science: It's image and impulse. It reflects perceptions, not performance.
Outrages like this would not happen, the Times suggested, if only the foundation would use socially responsible rating services of firms like the Calvert Group in Bethesda, Md. Well, so much for investigative reporting. Calvert not only was investing in BP, it had praised the company as an environmental leader.
In fact, Calvert, as other social research firms, utilizes no clear principles to evaluate investments. It subjectively rates companies, making evaluations based mostly on media accounts. For example, using its vaunted social screens, Calvert added Enron to its approved list in March 2001, just as Enron's ethical house of cards was collapsing. It owned HealthSouth, ImClone and other ethically-challenged firms.
The dark secret of "social investing" is that it is neither art nor science: It's image and impulse. It reflects perceptions, not performance.
In contrast, we already have a remarkably efficient way to determine what makes a corporation "good." Customers and investors vote on that every day. It's called the free marketplace and the stock market. It should come as no surprise that a Wharton study calculated that funds that layer on ideological screens perform worse than the general market by about 31 basis points a month, a huge discrepancy.
Social investing caught favor with union and public pension funds in the 1990s, as the market boomed. Favored SRI sectors––technology, communication, financial, and drug stocks––did well, undercutting some concerns that screening would limit investment diversity and endanger returns.
Ethical investors had a prime seat at the casino stock market of 2000, placing outsized bets on Adelphia, Level 3 Communications, USA Networks and the like--all profit-losing U.S. corporations whose gravity-defying share price rises temporarily pumped the returns of social investors. At the height of the frenzy, leading ethical funds stuffed nearly 40% of their clients' money in tech bubble stocks, far more than the sector was weighted in the S&P 500 index.
As the bull market ran its course, SRI advocates began making claims that "there is a growing literature in academic and professional investment journals that suggests socially responsible investing might produce higher risk-adjusted portfolio returns than merely using all available stocks in the equity universe."
Then came the pop. In retrospect, the competitive performance of SRI funds during this time period reflected sector bets--outsized investments in high P/E tech and com stocks--rather than the benefits of the particular social screens that were used. In contrast, social funds have historically underweighted manufacturing and energy and natural resource corporations, claiming they represent "dirty" industries likely to have adverse environmental impact. Those stocks had underperformed during this period.
Today, in the midst of another investment meltdown, social investors are again among the big losers. As of last year, before the sell-off began, almost every major diversified U.S. social investment firm, even many non-index firms whose weighting is not linked to the S&P, had 25% or more of their holdings in financials.
The largest socially responsible index fund-the Domini Social Equity Index Fund, which includes 400 U.S. companies that pass multiple and broad-based social screens--had 129% of the S&P standard in financials, but only 55% of its weighting in industrials, 59% in energy, and 66% in materials. As of this morning, Domini holds such investing stalwarts as Fannie Mae, Freddie Mac, Lehman, AEI, Citigroup and Wachovia.
Social researchers slapped "buys" on companies the loan structure of which they knew almost nothing about because they had great diversity programs and publicly committed themselves to sustainability initiatives--these companies had superficially progressive social initiatives but they didn't run their businesses very prudently--something social investors weigh less seriously than liberal litmus tests.
As of today, almost every social investment fund, stuffed with financials and underweighted in commodities, basic materials and resource stocks is trailing its more soberly managed benchmark over the past 1, 3 and 5 year periods. The Domini Social Equity Index with about $1.2 billion under management-is a typical disaster. It's trailed its benchmark, the S&P 500, by more than 2 percent annually over the past year and three year periods and by almost 3 percent annually over 10 years.
Even avoiding tobacco companies, which social investors equate with evil incarnate, is a questionable tactic, and morally questionable. While social investments have slid in recent years, tobacco firms have thrived. In 1999, then California State Treasurer Philip Angelides helped persuade officials at CalPERS and CalSTRS, on whose boards he sat, to sell $800 million in tobacco shares.
As Angelides said at the time, "I feel strongly that we wouldn't be living up to our fiduciary responsibility if we didn't look at these broader social issue. I think shareholders need to start stepping up and asserting their rights as owners of corporations. And this includes states and their pension funds."
Since these pension funds sold their tobacco shares, the AMEX Tobacco Index has outperformed the S&P 500 by more than 250 percent and the NASDAQ by more than 500 percent. That decision alone has cost California pensioners more than a billion dollars.
If one is genuinely antismoking, which is the more moral position: cashing in on well-run corporations like Altria and using market profits to fund favored social causes, or satisfying one's conscience and severely damaging worker pensions by investing in lackadaisically performing but politically correct companies?
Public and union pension funds will remain enormously important and growing factors in the financial markets for the foreseeable future. Certainly, as part of their fiduciary mandate to maximize investment returns for their beneficiaries, pension-fund trustees have a right and duty to lobby for changes in corporate behavior that could result in better returns for their pension holders. But judging by the words and actions of some pension funds activists, "shareholder value" has become a fig leaf to justify a range of actions that may put at risk, directly or indirectly, the retirement holdings of its members.
It's clear that if the goals of decision makers-those who run the pension funds--and stakeholders--the workers--are not the same--and that's often the case--pension plans should not engage in social investing because the political views and incentives of the two parties are not necessarily aligned.
It's also questionable whether social investing serves to promote the causes its advocates claim to embrace, let alone "do good." By implicitly encouraging the belief that the intentions of a business can be judged distinct from its economic impact, social investing often promotes corporate behavior that is neither socially progressive nor ethical, and may certainly result in adverse consequences to stakeholders, including pensioners.
In many instances, it amounts to union leaders or politicians gambling with other people's money in support of ideological vanity.
Pension funds are being dragged into treacherous waters where political and moral views threaten clear financial mandates. The use of social criteria may be fine for affluent investors or activists who gamble their own money and assume the extra risk to achieve their perceived political goals, but pension funds should be held to a higher standard.
Jon Entine is an adjunct fellow at AEI.