With the move toward so-called socially responsible investing, investors should be contemplating the real price of virtue.

A recent Environics public opinion poll for Environment Canada suggests that shareholders favour “social and environmental performance.” Everybody is in favour of virtue, but there is little agreement on what it is above and beyond basic (and important) rules like “Thou shall not kill” or “Thou shall not steal.”

Moreover, talk is cheap. People reveal their real preferences by their actual choices. Judging by their investment decisions, investors are not as politically correct as opinion polls imply.

Some investors do invest in what they perceive as virtue. At least, when private investors jump on the ethical bandwagon, they do it with their own money—as opposed to the Canadian Pension Plan Investment Board, which recently lashed out against executive stock options and decided to put taxpayers’ money where its corporate-governance mouth is. The question is: How much does virtue cost?

So-called “ethical funds” are in the business of “socially responsible investing” (SRI). The California Public Employees’ Retirement System (Calpers) announced last month that it will not invest in developing countries that don’t meet its SRI standards, even if this shaves off three percentage points from its emerging market portfolio. In Canada, there are now 54 SRI retail mutual funds, including those offered by Meritas Mutual Funds and by Ethical Funds. In the U.S., SRI accounts for as much as 5% of the money invested in publicly traded stocks.

Ethical funds vary a great deal, depending on their managers’ definitions of virtue and vice, but they generally eschew tobacco, alcohol, defence, guns and nuclear energy (they leave many of these opportunities to their beloved governments). They privilege the environment, “sustainable development” (whatever that means), and a politically correct conception of “human rights,” which often means trade union rights. They have proliferated recently, although specialized funds avoiding sinful industries have been known since 19th-century America.

“Vices are not crimes,” wrote 19th-century anarcho-capitalist philosopher Lysander Spooner. We still can legally invest in vice industries that have not been completely criminalized by the state. The Vice Fund (www.vicefund.com), created seven months ago, invests in alcohol, tobacco, gambling, and national defence. The presence of defence in the list of sins reminds us that what is a vice for some is a virtue for others.

Investing in vice often pays. Data from the Vice Fund indicate that, over the five-year period to June 30, 2002, stock prices have increased 8% in tobacco, 63% in alcoholic beverages and 116% in gambling, compared to a 12% increase in the Standard & Poor 500 Index. The Vice Fund (Nasdaq: VICEX) is down 15% since its creation, but this does not give a long-term picture. Over the five years preceding the fund’s creation, a sample portfolio would have increased by 53.0% in value; over a one-year period, the sample vice portfolio would have gained 17.6%, as opposed to a 20.1% loss for S&P 500.

SRI proponents argue that virtue pays at least as much as vice. In 2001, Professor Geoffrey Heal of Columbia Business School wrote that while SRI funds “are not among the top performers, they do perform above average.” Some SRI indexes do outperform standard indexes: Over the past five or 10 years, for example, the Domini 400 Social Index has outperformed the S&P 500—but the situation has been reversed since the beginning of this year.

There is contradictory evidence. On average, the share prices of the 46 ethical funds tracked by investment banker Thomson Financial (www.trustnet.com) have dropped by 24% over the past five years. The managers of Ethical Funds (www.ethicalfunds.com) state that “socially responsible investors are redefining the bottom line”; indeed, their Balanced Fund price has dropped 3.6% over the past five years.

One would think that either SRI has a cost, or else it is just like an ordinary investment. Professor Michael Knoll of Wharton writes: “Either some investments that would be acceptable on purely financial terms must be rejected for ethical reasons, or some that would be rejected on financial terms must be accepted for ethical reasons.” Theoretically, one would expect effective SRI to earn lower returns than non-constrained investment.

However, this cost may be low, depending on how one accommodates one’s ethics. Knoll convincingly argues that ethical investing can be nearly as profitable as unconstrained investing, provided that the cardinal rule of portfolio diversification is followed. A constrained portfolio cannot be as diversified as an unconstrained one, but the difference needs only generate a small cost. Indeed, Knoll reports evidence that SRI returns have been close to normal returns once we control for the larger weights given to small-capitalization and IT stocks in these funds.

In a nutshell, the more ethical investing differs from greedy investing, the higher the cost. And if the investor is in SRI for the money, well, he is not different from you and me.

Of course, anybody, including an investor, has the right to bear the cost of his own preferences. But nobody should be able to impose his religion on the rest of us. As Milton Friedman pointed out 40 years ago, one advantage of a free economy is that minorities, however unpopular, find businesses to cater to their tastes. Just as some bookstores “unethically” sold books banned by the Church in the Quebec of my childhood, businesses today cater to smokers, gamblers and gunowners. There is no reason why investors should be bullied away from satisfying the preferences of these consumers.

Three centuries ago, Bernard Mandeville noted that private vices are public virtues. Adam Smith’s 1776 Wealth of Nations expressed a similar idea: “By pursuing his own interest [every individual] frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”


Total performance to June 30, 2002

5 years Standard & Poor 500: 11.8%
Sample Vice portfolio*: 53.0%
3 years Standard & Poor 500: –27.9%
Sample Vice portfolio: 41.7%
1 year Standard & Poor 500: –20.1%
Sample Vice portfolio: 17.6%

*25% in each of tobacco, alcohol, gambling and defence

Source: Vice Fund, National Post