A systematic approach to social investment

Investors who subscribe to this view may be interested in ESG issues because they’re incorrectly priced and, by correctly weighing ESG implications, they can generate higher returns for a comparable risk.

This view implies there’s a market inefficiency, but not all investors have pursued an ESG-centred investment strategy, which suggests they’re unpersuaded by the magnitude of the opportunity. 

Model behaviour

There are some investors whose primary motivation is not to maximise returns but rather to act in a socially responsible manner. This has attracted the attention of behavioural economists like Bénabou and Tirole (2010) who suggest such behaviour can be explained in three different ways. 

The first is a win-win model, that we ‘do well by doing good’. This is a broader version of the view there’s a market inefficiency and, while investors and company management remain focused on short-term goals, the longer-term risks encapsulated in ESG issues are unaddressed or mispriced. 

In this case there are two potential alternative investment strategies: either to assume ESG risks are wrongly priced and to avoid them in the expectation of producing better risk-adjusted returns; or to assume ESG risks are correctly priced, that returns can be improved and to persuade companies to reduce their ESG risks.

In either scenario, an investor could plausibly ‘do well by doing good’.

There’s an assumption of stakeholder demand for companies that engage in philanthropic activity on their behalf and that those companies will respond by ‘doing good’ or refrain from ‘doing harm’.

The second pro-ESG model is that of ‘delegated philanthropy’ which sees the firm as a channel for the expression of citizens’ values. In this case, there’s an assumption of stakeholder demand for companies that engage in philanthropic activity on their behalf and that those companies will respond by ‘doing good’ or refrain from ‘doing harm’, thereby championing their stance. 

Examples where companies have sought to appeal to the philanthropic interests of stakeholders include the Fairtrade and Product (Red) brand campaigns and investment products that are tailored to various ESG views.

This model doesn’t necessarily challenge Friedman’s idea of a business’s social responsibility because the firm responds to customer demand and maximises profit.

The third pro-ESG model is ‘insider-initiated corporate philanthropy’ in which the company pursues its own management’s objectives rather than those of its shareholders.

Because management is seen to act as principal and not as an agent of shareholders, there’s a presumption that profit is not maximised. For this behaviour to persist, management needs to be invulnerable to external influences, such as from shareholders.

In practice, this phenomenon is difficult to identify, as management may ascribe its principal-like objectives to agent-like motives.