1. Is it “Bad” to be a “Good” Investor? Kevin Davis Commonwealth Bank Chair of Finance Director, Melbourne Centre for Financial Studies

2. © Kevin Davis Overview and Outline Objective: outline and interpret recent evidence on implications of SRI/ESG (“Good”) Investing Finance 101 – making sense of the evidence What are the questions? The evidence –do “good” investors pay a price? –what influence do good investors have? –Do “good” companies do good well? A postscript: difficulties in being a “good” investor in a complex financial world

3. © Kevin Davis Almost/Slightly Efficient Markets Don’t bother, if it really was there, someone would have picked it up already Share prices reflect available information to some degree

4. © Kevin Davis Almost/Slightly Efficient Markets Implications –It is unexpected news/ changed opinions which cause prices to change unexpectedly Such as announcement of an unanticipated penalty scheme for emissions But not commencement of a widely anticipated penalty scheme –Share price of those likely to be adversely affected will have previously fallen –Being “ahead of the pack” (and correct) generates out- performance Correctness may relate to fundamentals or to just identifying where the pack is going!

5. © Kevin Davis Almost/Slightly Efficient Markets If “good” investors relatively few –No effect on share prices of “bad” companies –Little effect of, and cost to, being a “good” investor Investment returns similar to other investors Unless “good” investors prescient regarding poor future economic performance of “bad” companies Growing “good investor” importance –Increases relative share price of “good” versus “bad” companies better eventual returns for early “good” investors –Regardless of whether “bad” companies are bad economic performers

6. © Kevin Davis Almost/Slightly Efficient Markets If Many “good” investors who avoid “bad” cos. –Lower share price relative to book value (& good cos.) If there is no “economic” basis for avoidance –Investors in “bad” companies get better rate of return –But bad companies have higher cost of capital If there is an “economic” basis –eg “good” investors predict bad outcomes for bad cos. –ESG investors may ultimately have better returns –And bad companies have higher cost of capital

7. © Kevin Davis “Good” Investing: Some questions Does it reduce investor returns? What performance benchmarks should be used? Does it help socially responsible companies? Does it affect company behavior? Do investment selection techniques matter? Do portfolio characteristics differ? Are clients of ESG fund managers different? How should ESG fund managers be compensated? Is “exit” or “voice” a more effective way of being “good”?

8. © Kevin Davis Recent Research Findings 2008 Journal of Banking and Finance paper by Renneboog, Horst and Zhang –Reviews 16 papers on SRI mutual fund performance published between 1992 and 2008 Funds from US, UK, Europe etc –Comparisons of SRI and non-SRI fund performance Investment rates of return (adjusted for systematic risk differences)

9. © Kevin Davis Recent Research Findings Rarely is there a significance difference –For UK and USA –But perhaps SRI fund underperformance in Continental Europe and Asia-Pacific Indication of bias towards small-cap stocks No differential (or good) market-timing ability Performance of SRI funds may improve with age –More experience, or just “ahead of the pack”

10. © Kevin Davis Recent Research Findings Maybe no difference in returns, but… “good” investing may lead to lower share prices for “bad” companies “good” has a number of dimensions Galema, Plantinga, Scholtens ( JBF 2008) –No difference between risk adjusted returns for portfolios selected on good v bad SRI characteristics Characteristics obtained from KLD Research and Analytics, US data for 92 -06 –SRI characteristic differences reflected in share prices (market/book ratio)

11. © Kevin Davis Recent Research Findings “The wages of sin is…” Romans 6:23 –Actually, higher returns, SIN STOCKS outperform Less “Sinvestors”, but many “Sinsumers” –Low share demand but strong underlying economics

12. © Kevin Davis Recent Research Findings Expect lower share prices, higher returns Hong & Kacperczyk (SSRN 2005) TAG stocks –30 b.p per month return premium p.a. 1962-2003 –Lower market/book ratio (17% lower) –Less held by institutions (but not mutual funds) –Less covered by sell-side analysts Investors conforming to social norms incur a cost TAG stocks face a higher cost of capital

13. © Kevin Davis Recent Research Findings Little study of how to best be “good” –Negative/positive screens, “best in breed” portfolios… Derwall et al (FAJ 2005) –Environmentally “best in class” portfolio returned 12.2% p.a versus 8.9% for “worst in class” –Significant differences after allowing for risk factors –using Innovest ratings of firms for 1995-2003 Kempf and Osthoff (EFM 2007) –positive significant returns from portfolio constructed as long 10% best SRI and short 10% worst SRI –use KLD characteristics & best in class screens 92-04

14. © Kevin Davis Doing “good” What role for shareholder activism by funds? Black (1998) “institutions achieve the effects on firm performance that one might expect from this level of effort – namely, not much” Karpoff (2001) – leads to changes in governance structures but negligible effects on share values and earnings

15. © Kevin Davis Shareholder Activism Barber (2006) –Calpers focus list has generated large wealth creation gains –Reflects shareholder activism focused on manager- owner agency problem. –Social activism problematic for pension funds Becht et al (2008) –Clinical study of Hermes (BT Pension Scheme) –activism via private unobservable interventions –Exhibits return outperformance

16. © Kevin Davis CSR and Corporate Performance Are “good” firms better stock market performers? Orlitzsky et al (2003) meta study –CSR generally associated with better financial performance –Two way causality (they can afford to) –Benefits due to external reputation rather than internal efficiency Lougee and Wallace (2008) –Measured CSR performance has declined – because of emergence of more CSR issues –Reducing CSR weaknesses has more effects on financial performance than increasing strengths –CSR implemented as a form of risk management

17. © Kevin Davis A Postscript: It’s difficult to be “good” Did your fund invest in CDO’s ?

18. © Kevin Davis Conclusion Evidence somewhat mixed, influenced by historical emergence of “good” investing –No clear evidence of underperformance –Affects companies via share price impact –The style of “good” investing may matter “Voice” (activism) rather than “exit” (investment decisions) may have more influence upon investment returns and corporate social responsibility –CSR aimed at external perceptions