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A bad way to invest responsibly

·4 mins

A while back, I decided to consider Socially Responsible Investments (SRI).
As I see it, the question is the following:

Is it most effective to spend money on improving the influence of my investments, or to donate money to charities?

This first article is about the most common approach: something with no effect that costs money.

Turns out, many investment companies hope you will pay them to improve the impact of your investments.
A popular methodology is “filters”, also called “negative screening”. Investment funds with filters commit not to invest in “controversial assets”. “Controversial assets” differ from one fund to another but generally include: Nuclear energy, Coal, Tobacco, Gambling, Alcohol and Pornography.

Thanks to these companies, for a modest price of 0.09% and missing out on a few assets, you made the world a better place.
Or have you?

In my understanding, filters have no impact because they require very high thresholds, yet they provide no leverage.
Let’s take tobacco as an example. It makes for about 0.59% of the stock market 1. For tobacco companies to have difficulty funding their development, on the order of 99.5% of all investible money would need to be refused to them 2. Only if this threshold were reached, then the cost of capital would increase for tobacco producers.

Getting 99.5% of all money worldwide to reject Tobacco, or as another example 97% of all money to reject coal is rather unrealistic, as different regions have different values. For example, 18% of the worlds’ wealth 3 is in China, where the tobacco industry provides 7-10% of total central Chinese government revenues.
Compare the unlikely success of a globally coordinated action with the very feasible local smoking bans: these require just on the order of 50% of legislators, and they already have an effect if they happen just in a specific region.

Thus, it seems that the consensus needed to prevent the funding of “controversial assets” would only be reached at a point after they have been made illegal in most major economies.

It could be that we find investment filters appealing because we are used to thinking as consumers. Consumer selection does not suffer from a threshold effect. If even just 1% of the population stops eating meat, then after a while ~1% less meat is produced. If 1% of the population stopped financing meat production but kept eating meat, I don’t expect anything would change.

Positive screens #

Oh, and what about “positive screens” then, where a fund only invests in virtuous assets?
On paper, it seems that a “positive screen” selecting 20 investments is equivalent to a filter excluding all investments but 20. This reasoning is mostly sound. Thus, many funds with “positive screens” are really filtered funds, and ineffective.

As I understand, the exception is if both of the following conditions are met:

  1. The fund selects investments that would otherwise not have been considered.
    For example, your local supported employment company is very unlikely to be on the stock market at all. If a socially responsible fund went out in the field to select such investments, that would no longer be equivalent to just filtering all other stocks.
  2. You either cannot support the cause through a tax-deductible charitable donation, or believe that paying taxes is more desirable than donating to charities.
    Otherwise, you’d be better off letting whichever enterprise the investment consists of finance itself at market rate, and compensating their risk premium by a tax-deductible donation.

In practice, these conditions are probably only met in very specific cases… maybe private foundations?

  1. More correctly, 0.59% of all publicly traded stocks available to western investors, but this is a good enough approximation for this example. ↩︎

  2. More precisely, the cost of capital will be at most increased to the same percentile as the percentage of investible money that is refused to them. ↩︎

  3. 18% of the world’s wealth doesn’t necessarily mean 18% of investible money, but it gives an idea. ↩︎