1. Introduction
In the last decade, more and more investors have been aware of impact investing, while companies are under pressure to engage in corporate social responsibilities (CSR) to have sustainable development. Both institutional and individual investors who advocate for impact investing will use criteria based on environmental, social, and governance (ESG) considerations to build their investment portfolios.
Riedl and Smeets (
2017) explain why investors apply impact investing (ESG) strategies.
Goldstein et al. (
2021) develop an equilibrium model to address the relationship between investors’ heterogeneous preferences and the ESG investment price-formation mechanism. Impact investing is aligned with an investment philosophy that believes that investing in companies that are ethical can generate positive social outcomes. This emerging practice of impact investing raises several issues in the investment area. First, when investors implement the impact investing strategy, they use positive or negative filters to build their investment portfolios. The negative filtering is to avoid investing in companies or industries that are harmful to society, while the positive filtering is to invest in companies that are socially responsible and ethical for society.
When an investment decision takes corporate social responsibility into consideration, it adds one more dimension to the mean-variance framework that modern portfolio theory addresses (
Merton 1987).
Fama and French (
2007) suggest that investors’ preference for CSR or business ethics is one of the factors that determine expected returns.
Pedersen et al. (
2021) develop an assets pricing model that addresses the ESG-efficient frontier.
Zerbib (
2020) incorporates investor tastes for CSR into a Sustainable-CAPM model and finds empirical evidence that supports the model. Therefore, from the investors’ perspective, it is an empirical question to examine whether impact investing can do well by outperforming the benchmark. Second, from the companies’ perspective, the principal basis of agency theory is that ownrs of companies delegate the “work” of running the company to the managers of the firm or agents (
Eisenhardt 1989). Accordingly, corporate governance mechanisms are structured in such a way to align the interests of managers and shareholders (
Leuz et al. 2003), with the goal of maximizing wealth. In general, while investors are guided by the maximization of wealth, some investors are also guided by a sense of “moral duty” (
Etzioni 1988). Researchers have found that social norms influence economic behavior (
Elster 1989), even when profit is lower.
Akerlof (
1980) and
Romer (
1984) provide evidence that individuals will often follow social customs that result in an individual disadvantage if it would mean a loss of reputation to do otherwise. Hence, companies are showing a greater interest in highlighting their efforts at corporate social responsibility and ethical decision making, as evidenced by information collected and displayed on websites such as
CSRwire (
2019) and
Ethisphere (
2018).
In this paper, we conduct an empirical analysis to investigate the investment performance of an impact investing strategies. Specifically, we examine the investment return of an impact investing portfolio that consists of the most ethical firms based on the ethical scores published by the Ethisphere Institute (
Ethisphere 2018). The Ethisphere Institute compiles a listing of the world’s most ethical companies by compiling an “EQ” score. This proprietary score is derived from a set of relationships that are determined by responses to survey questions. The initial data are self-reported by companies. After data are submitted, Ethisphere conducts a review process that includes a number of independent verification processes in order to validate each company’s self-reported information. The score is comprised of a framework based on ethics and compliance programs (35%); corporate citizenship and responsibility (20%); culture of ethics (20%); governance (15%); and leadership, innovation, and reputation (10%).
We begin our investigation of the impact investing strategy by building an equal-weighted portfolio that consists of the most ethical firms. We re-balance the portfolio each year based on the most ethical firms announced by the Ethisphere Institute in that year. As a result, the number of stocks in the portfolio varies, ranging from 44 stocks in 2007 to 73 stocks in 2015. Using the CAPM and the Fama–French factor models, we run time-series and cross-sectional return regressions to explore the investment performance of the impact investing portfolio. In their equilibrium model,
Pástor et al. (
2021) explain that ESG stocks have higher prices if impact investors have a favorable taste for ESG stocks; however, the realized returns might be lower when investors’ preferences shift unexpectedly. To empirically test the model developed by
Pástor et al. (
2021), we predict that the equal-weighted portfolio that consists of the most ethical firms will generate lower returns if investors are willing to pay a price premium to those companies’ stocks. In the meantime, there exists the possibility that the most ethical firms will be undervalued due to information asymmetry or the shift of investors’ taste for ESG stocks. If so, we predict that the portfolio will have higher returns than comparables. So, we need to investigate the financial analyst coverage of the most ethical firms to see if there is any information asymmetry. The empirical analysis of stock valuation helps us explore the stock return and pricing dynamics and seek reasons for the extra return of the impact investing portfolio.
In the literature, there are many studies that have investigated the investment performance of ESG stocks and explored the relationship between corporate governance and stock performance. The empirical evidence so far is inconclusive. Some studies find a positive relationship between ESG stocks and investment returns (
Khan et al. 2016;
Lins et al. 2017;
Albuquerque et al. 2019), while other papers record a negative relationship between ESG investment and stock returns (
Chava 2014;
Bolton and Kacperczyk 2021).
Cornell and Damodaran (
2020) assert that ESG firms have higher valuations because being socially responsible will make the firm more profitable and less risky.
Pedersen et al. (
2021) point out that the positive relationship between corporate governance and profitability is sensitive to the metrics of ESG and profitability measures. Yet,
Nollet et al. (
2016) find a negative relationship between ESG and return on capital when they use S&P 500 firms in their sample. The inconclusive empirical findings are largely due to the alternative measures of ESG and various investment performance metrics used in the various studies, which leave the gaps in research. One of the gaps in the literature is using the business ethics measure as a dimension to explore the relationship between ESG and investment performance. In this paper, we fill this gap by using the most ethical firms to build an impact investing portfolio to examine the relationship between ESG and stock returns.
Our paper makes several contributions to the literature on impact investing and investment performance more generally. First, our empirical analysis outcome shows that the portfolio consisting of the most ethical firms generates an extra return compared to benchmarks. We run various return regressions, including time-series return and cross-sectional return regressions, as well as Fama–French factor models, and our results are consistent with our prediction, which expects that investing in the most ethical firms has a better investment performance over benchmarks. Our findings provide empirical evidence that supports the impact investing strategy, indicating that companies acting ethically can also do well to impact investors. Second, by running valuation regressions, we find that the most ethical firms are undervalued compared with their comparable peers. Typically, investors expect that investing in good companies can generate higher returns. However, the assets-pricing theory asserts that a company’s good characteristics might be priced in an efficient market, and therefore, good companies should have higher stock prices and lower returns. While our return analysis results indicate that investing in the most ethical firms gains a higher return, consistent with investors’ expectations, our valuation regressions show that the most ethical firms are undervalued, implying that the higher return is likely to be caused by the lower stock prices, consistent with the assets- pricing theory as well.
Conceivably, investors who wish to invest in, or work for, a “most ethical” firm would still have a goal of wealth maximization in addition to their sense of moral duty (
Etzioni 1988). In order to achieve both goals, investors could pursue a choice of strategy similar to possible strategies outlined by
Cummings (
2000) when investors are trying to choose investment in a socially responsible company. Theoretically,
Goldstein et al. (
2021) develop a rational expectations equilibrium model to explain the interaction between investors’ heterogeneous preferences to ESG investment, differential exposure to ESG information, and investment performance.
Lo and Zhang (
2021) propose a quantitative framework for assessing the investment performance of impact investing in order to e the condition under which the reward exceeds the cost of impact investing. Before ESG and CSR evolved into the mainstream in recent years,
Riedl and Smeets (
2017) conducted a survey to understand the reasons why investors hold socially responsible investment funds. They find that investors’ intrinsic social preferences and social signaling are major reasons that cause investors to hold socially responsible investment funds. Their empirical findings suggest that although ESG investors also have financial motivations when making an impact investment decision, they are willing to accept lower financial returns from ESG investing when their social preferences dominate over financial motivations.
Practically, for investors who have strong social preferences in their investment, to invest in an “ethical” firm, they could perform research on their own of which companies have better ethical performance records. However, such research could be quite time-consuming. Investors could choose mutual funds or other investment vehicles that only consist of companies that meet some sort of ethical standard. Or, they could choose to only invest in companies on the “Most Ethical Companies” list. As such, companies may prefer to be listed on the website for several reasons. For one, being listed there would reflect the company’s image of promoting ethical standards. For another, company management may seek to improve financial or market performance by attracting investors who choose to only invest in ethical firms. However, from the company’s viewpoint, is it worth it to be an “ethical firm”? Is their performance better or less risky?
Evidence is mixed regarding the performance of ethical companies.
Cummings (
2000) tests the performance of ethical investment trusts in Australia and finds that on a risk-adjusted basis, there is no significant difference between the financial performance of these trusts and performance measures of three common market benchmarks (the Smaller Companies Index, the Industry Average Index, and the All Ordinaries Accumulation Index). However, he finds that the ethical trusts have slightly superior financial performance against their respective industry average indexes.
Mallin et al. (
1995) study the returns of ethical trusts in the U.K. and find that ethical trusts outperformed non-ethical trusts on a risk-adjusted basis. Other authors (
Levis 1988;
Luther et al. 1992) find that ethical trusts have a small company bias and relate the performance of the trusts to the fact that smaller companies have been shown to outperform the market.
On the other hand,
Robson (
1986) studies the investment performance of Australian funds and finds inferior market performance. Similarly,
Diltz (
1995) finds that ethical screening has little impact on portfolio performance. In fact,
Hong and Kacperczyk (
2009) have shown that stocks that represent various societal vices—so-called “sin” stocks—have higher expected returns than otherwise comparable stocks.
In terms of stock market prices, previous research has also produced conflicting evidence for ethical or socially responsible firms. Several studies show a positive reaction to social disclosure.
Ingram (
1978) finds that firms in certain market segments that disclosed social initiatives outperformed non-disclosing firms.
Anderson and Frankle (
1980) find that firms who continuously disclose social initiatives had greater market returns than both non-disclosing firms and newly disclosing firms.
However,
Belkaoui (
1976) finds that for companies who disclosed pollution-abatement expenditures, the stock price reaction was positive for the first four months after disclosure, followed by a negative market effect over the next 20 months. Other authors have found a similar negative effect on the performance of firms who disclose social expenditures (
Spicer 1978;
Vance 1976;
Freedman and Jaggi 1982;
Ingram and Frazier 1983).
Kaustia et al. (
2009) cite numerous studies that find that stocks of companies that are deemed “good” (in other words, admired in various ways) do not provide superior returns (see
Kaustia et al. 2009 for citations of these studies).
Yet, there is overall support for ethical and environmental policies.
Reichert et al. (
2000) report a relationship between firm size and ethical and environmental policies. They also note that because the shareholder loss is often quite sizable when corporate executives are indicted for unethical behavior, the “financial markets now take a dim view of unethical behavior” (p. 53). However, does that mean that ethical firms can enjoy both high prices and high stock returns? In our paper, we follow
Kaustia et al. (
2009) and
Hong and Kacperczyk (
2009) to examine whether companies on the “Most Ethical Companies” list have better performance than companies that are not on the list. On the one hand, when the impact investors are aware of those most ethical companies, they might be willing to pay a price premium to the most ethical firms. Or, if many investors include the most ethical firms in their investment portfolio, given their ethical norm, the price discovery mechanism of the stock market will make their stocks be overvalued. When stocks are overpriced, the return will be lower. On the other hand, investors expect ethical companies to generate a higher return (
Kaustia et al. 2009), and according to the asset-pricing theory, a higher return is associated with a lower stock price. Therefore, we propose our hypotheses based on the findings of
Kaustia et al. (
2009). Given that investors expect good companies to generate a higher return, we propose:
Hypothesis 1a (H1a). The most ethical firms have higher returns than comparables.
Then, following the asset-pricing theory, we propose:
Hypothesis 1a (1b). The most ethical firms have lower stock valuations than comparables.
The rest of our paper is organized as follows. In
Section 2, we describe the data collection, sample construction, and research design. Testing results are presented and discussed in
Section 3. Finally,
Section 4 offers a conclusion.
3. Results and Discussion
Results of our regression models appear in
Table 3,
Table 4,
Table 5 and
Table 6.
Table 3 reports the testing results of CAPM and Fama–French four-factor models, as expressed in Models (1) and (2). We run the time-series regressions to test the factor model. The dependent variable,
EXCOM, is the difference between the monthly return of an equal-weighted portfolio of the most ethical firms in month
t and the monthly return of an equal-weighted portfolio of comparable firms in the same industry segment that is classified by the two-digit SIC code.
SMB,
HML, and
UMD are investment return factors in the literature. We download the monthly return factor data from Compustat. The interest of estimation is the alpha expressed by the constant in the regression. It measures the excess return. In variations of factor models, the coefficients of constants are consistently positive at 1% and 5% significance levels, respectively. Both CAPM and two-factor models yield positive alphas of 20 bps with 1% significance, indicating that the most ethical firm portfolio generates a 2.43% excess return annually. The three- and four-factor models have 11 bps alphas with 1% and 5% significance, respectively. This means that the most ethical firm portfolio outperforms its comparables by 1.36% annually. In addition, the coefficients of all factors in all testing models are significant at a 1% level, with one exception. The coefficient of
HML in the four-factor model is insignificant. That is the only exception in the time-series regressions. The consistent and significant estimation results reveal that the impact investing portfolio consisting of the most ethical firms yields an excess return over time.
To investigate the return performance of the impact investing portfolio thoroughly, we also use a cross-sectional variation to run regressions in Model (3). Our estimation results are consistent and conservative with various methodologies, including the
Fama and MacBeth (
1973) with
Newey and West (
1987) standard errors, and pooled and panel regressions controlling for industry clustering standard errors. In Model (3), the coefficient of the dummy variable,
β1, is the focus of tests. It reflects whether the most ethical firms have an extra return over comparables. To control for firm characteristics, we include a list of control variables that have been defined earlier.
The regression results are presented in
Table 4. We report the estimation results using the
Fama and MacBeth (
1973) estimation methodology with
Newey and West’s (
1987) standard errors.
1 Our main test result with all control variables, including size, market-to-book ratio, the past debt ratio, past return, beta, past turnover, and firm age, is reported in column 5. The coefficient of the ethical firm dummy is 0.0052 and statistically significant at a 5% significant level, indicating that the ethical firms outperform their comparables by 52bps monthly or 6.42% annually. While the 6.42% extra return is material in amount, the estimation results are consistent and solid, with the majority of control variables being statistically significant at 1% or 5% level of significance, respectively. Consistent with the literature, the coefficient of
LOGSIZE is negative and significant at a 5% level, revealing that large firms have lower returns. The insignificant coefficient of BETA predicts that beta is not correlated to the return statistically in this cross-sectional regression, a finding that is consistent with the literature as well. The statistically significant coefficients of other control variables suggest that the market-to-book ratio, past return, past turnover, past debt ratio, and firm age are effective predictors when examining the cross-sectional stock returns. The testing results remain significant across various specifications when we relax controls. As reported in columns 1 to 4 in
Table 4, in the estimations with a varying number of control variables, the coefficients of the ethical firm dummy are 0.002 and stay statistically significant at 5% and 10% levels of significance. This result suggests that the most ethical stocks outperform their comparables by 20 bps monthly or 2.43% annually.
Both time-series and cross-sectional tests of the return of the most ethical firms generate significant excess returns consistently. The testing results reveal that investing in the impact investing portfolio that consists of the most ethical firms can obtain an extra return and that the most ethical stocks have higher returns instead of prices. To further investigate the return performance mechanism of the most ethical firms, we conducted a stock-valuation analysis with various stock-valuation measures.
The results in
Table 5 reflect the different measures of stock valuation. We estimate the model by running panel regression with industry group clustering standard errors and the
Fama and MacBeth (
1973) regression with
Newey and West’s (
1987) standard errors. Our results from the above two estimation methodologies are consistent. In column 1, stock valuation is measured by the market-to-book ratio (
MB). In columns 2 and 3, we measure stock valuation with the log of the price–earnings ratio (
LOGPE) and log of the price over earnings before interest, taxes, depreciation, and amortization (
LOGPEBITDA), respectively. The coefficient of the ethical stocks (
ETHDUM) signals the stock valuation of the most ethical firms over their comparables. Following the literature, we include a vector of control variables to assess firm characteristics. Our independent variables include
TWODIGDUM and
NASD, as previously explained.
ROE is the return on equity.
RDSALES is the ratio of research and development expenses to sales.
RDMISS is a dummy variable equal to 1 if company
i’s R&D expenditure in year
t is missing.
FROE is next year’s
ROE. Similarly,
F2ROE and
F3ROE represent the
ROE for the subsequent second and third years. The estimation of the testing models creates negative coefficients of the ethical dummy and identifies control variables correlated with the valuation. Our findings from the stock-valuation analysis are similar to findings in the literature. The negative and statistically significant coefficients of
ETHDUM propose that the most ethical stocks are priced lower. Specifically, in column 1, we use
MB as the valuation variable. The coefficient is -0.004 but insignificant. In column 2, when we use
LOGPE as the dependent variable in the regression model, we obtain a −0.128 coefficient on
ETHDUM. It is statistically significant at the 1% level. Results in column 3, which uses
LOGPEBITDA as the dependent variable, confirm this finding with all control variables consistent with the results reported by
Hong and Kacperczyk (
2009). In column 3, the coefficient on
ETHDUM is −1.842 and significant at the 1% level. The coefficient of
TWODIGDUM is positive and significant, indicating that companies in the same two-digit SIC code industry segments as ethical firms have their stock prices higher than those of other stocks. The coefficients of
ROE,
RDSALES, and
FROE are consistent in signs with those reported by
Hong and Kacperczyk (
2009) and statistically significant at the 1% and 5% level, respectively, suggesting that
ROE,
RDSALES, and
FROE are factors influencing stock valuation. Coupled with our earlier result that the most ethical stocks have a higher return, we can conclude that stocks of the ethical firms are priced lower but have a higher return.
The assets-pricing model displays that investing in the portfolio consisting of the most ethical firms achieve at least 11 bps monthly or 1.36% annual extra return over time, adjusted for all risk factors, while the cross-sectional return regression model predicts that the most ethical stocks outperform their comparables by at least 20 bps monthly or 2.43% annually. Then, the stock-valuation analysis results suggest that the extra return of the most ethical firms is associated with lower stock prices. Whereas the investment return performance and stock valuation analyses provide empirical evidence that supports our hypotheses H1a and H1b, the question of whether investors expect higher returns or higher prices from the most ethical firms remains unanswered. The related literature provides two models, suggesting two explanations.
Merton (
1987) addresses the stock-valuation mechanism from the perspective of information. It asserts that incomplete information or uninformed investors are associated with underpriced stock valuation.
Heinkel et al. (
2001) analyze the price implications of ethical investing from the angle of investors’ risk aversion level. According to
Heinkel et al.’s (
2001) model, individual investors are more risk-averse than institutional investors. Therefore, when individual investors make impact investing, their higher risk factors will be priced into the stock’s valuation. To reveal the information environment of the most ethical stocks, we run an additional test to examine the financial analyst coverage of the most ethical firms.
We use the
Fama and MacBeth (
1973) estimation methodology to run Regression Model (4). The regression results are shown in
Table 6. The coefficient of
ETHDUM in column 6 is −0.04 and statistically significant at 10% in the most rigorous estimation models that control for the majority of firm characteristics, indicating that the portfolio of ethical stocks is not recommended more frequently than our portfolio of comparison stocks. Analyst recommendations are positively related to size (
LOGSIZE), market-to-book value (
LOGMB), price (
PRINV), standard deviation (
STD), and being listed on the Nasdaq index (
NASD). Stocks that had a lower return the previous year were not recommended by analysts.