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Is socially responsible investing worth it?

Following Betteridge’s Law of Headlines, you may infer that the correct answer to this question is “no”. 

I was inspired to write this post while perusing the latest scandal around Herbalife, a very large company which appears to be a giant pyramid scheme. This presentation, done by a prominent hedge fund that has taken a massive short position, is an impressive takedown of the company. (Here is an accompanying website.)

While the company produces cash for shareholders, the thesis is that the company will eventually deteriorate due to legal issues and business model unsustainability. The most interesting take, however, came from an investor with a slightly different take:

“I am utterly convinced by everything in Bill Ackman’s presentation except the final conclusion — that Herbalife’s stock will collapse,” said Hempton, who also is a noted short seller. ”I took a long position on Christmas Eve.

“I suspect that Herbalife is so profitable and so powerful they will see Mr. Ackman’s attack off — and the easiest way to do that is to buy back stock (and make the stock go up),” he adds. “Mr. Ackman has given them the incentive to return their huge (but tainted) profits to shareholders (and I plan to be a recipient shareholder).”

This illustrates a fundamental problem with socially responsible investing (SRI), or paying a premium for one type of asset over another, holding relative risk and return constant: there will always be people that only care about the money.

This means two things will happen: first, this group will bid back up the price of non-socially-responsible investments (because they only care about return characteristics), confounding any attempt to create a non-financial premium. Second, this opportunity to correct the price imbalance just gives this group an opportunity to make more money! So not only should SRI not have a lasting effect, but it should also reward non-SRI investors in the bargain!

To illustrate this, imagine that there are two groups of people (“do-gooders” and “cold-hearts”) and two types of investments (“SRI” and “non-SRI”). Let’s imagine that the SRI and non-SRI investments offer the same risk/return characteristics and are priced at par — 100.

Let’s say that to the do-gooders, the SRI assets have a non-financial premium of 20, and the non-SRI assets have a non-financial premium of -20, so the two types of assets are worth 120 and 80, respectively. To the cold-hearts, there is no non-financial premium; both are just worth 100. 

If we modeled this in two stages, first the do-gooders would sell their non-SRI assets to buy SRI assets until they hit their equilibrium prices of 120 and 80, respectively. Then, the cold-hearts would just undo all that, effectively arbitraging across the two (financially) equivalent classes of assets, until their prices were back at 100/100. 

Of course, this interplay would not happen in discrete stages — it happens continuously — but the effect is the same. SRI is a broken concept. To drive investment towards the things that we want, we need to make them more profitable, plain and simple.