Do Socially Responsible Investors Have It All Wrong?

Fossil fuels divestment is a widely debated topic at many college campuses, including my own. The push, often led by students, to divest from fossil fuels companies is an example of the socially responsible investing (SRI) movement. SRI strategies seek to promote goals like environmental stewardship, diversity, and human rights through portfolio management, including the screening of companies involved with objectionable products or behaviors.

It seems intuitive that the endowment of a foundation of educational institution should not invest in a firm whose activities oppose the foundation's mission. Why would a charity that fights lung cancer invest in tobacco, for example? But in a recent Federal Reserve Board working paper, "Divest, Disregard, or Double Down?", Brigitte Roth Tran suggests that intuition may be exactly backwards. She explains that "if firm returns increase with activities the endowment combats, doubling down on the investment increases expected utility by aligning funding availability with need. I call this 'mission hedging.'"

Returning to the example of the lung-cancer-fighting charity, suppose that the charity is heavily invested in tobacco. If the tobacco industry does unexpectedly well, then the charity will get large returns on its investments precisely when its funding needs are greatest (because presumably tobacco use and lung cancer rates will be up).

Roth Tran uses the Capital Asset Pricing Model to show that this mission hedging strategy "increases expected utility when endowment managers boost portfolio weights on firms whose returns correlate with activities the foundation seeks to reduce." More specifically,

"foundations that do not account for covariance between idiosyncratic risk and marginal utility of assets will generally under-invest in high covariance assets. Because objectionable firms are more likely to have such covariance, firewall foundations will underinvest in these firms by disregarding the mission in the investment process. SRI foundations will tend to underinvest in these firms even more by avoiding them altogether."

Roth Tran acknowledges that there are a number of reasons that mission hedging is not the norm. First, the foundation may experience direct negative utility from investing in a firm it considers reprehensible-- or experience a "warm glow" from divesting from such a firm. Second, the foundation may worry that investing in an objectionable firm will hurt its fundraising efforts or reputation (if donors do not understand the benefits of mission hedging). Third, the foundation may believe that divestment will directly lower the levels of the objectionable activity, though this effect is likely to be very small. Roth Tran points out that student leaders of the Harvard fossil fuel divestment campaign acknowledged that the financial impact on fossil fuel companies would be negligible.