A study of BNP Paribas Asset Management’ Socially Responsible Investment (SRI) Best-In-Class universe of European stocks highlighted a size effect that determines financial performance. Study author Vincent Lapointe explains.
Why has the interest in SRI risen recently?
In light of the recent economic and ecological crises, firms’ Environmental, Social and Governance (ESG) practices have become more visible. So too has their sense of Corporate Social Responsibility (CSR) – their need to take social, ethical and environmental responsibility for their actions, even when not required to by law. This has heightened the interest in SRI, which is about investing on the basis of financial and extra-financial criteria and seeking added value from both of these elements.
Is there any connection between financial and extra-financial performance?
The level of extra-financial performance – the quantity and quality of CSR actions – interacts with the value of firms via their cost of capital: those with no CSR policies are seen as being risky. But it also interacts with the value of firms via the profits their activities generate – depending on how their CSR actions are motivated by the search for profit. Cheaper capital and higher profits are reflected in a higher share price.
That said, many studies show the average performance of SRI funds to be similar to that of traditional funds. This has to do with how efficient markets are with information and/or there being fewer diversification opportunities with SRI funds. If markets rapidly digest all the data that can affect a firm’s value, one cannot capture the related revalorisation. Conversely, if markets are inefficient, one can obtain abnormal returns by systematically buying into 'responsible' firms before this characteristic is priced in.
How do you choose the companies that perform the best extra-financially and assess their financial performance in a portfolio?
The SRI Best-In-Class investment process of BNPP IP excludes from the investment universe companies that do not respect fundamental principles (e.g. the UN Global Compact), or being active in controversial sectors (e.g. the 'sin stocks'). With the remaining universe, we privilege companies that show best-in-class ESG practices. These are the ‘IN’ companies; those excluded are the ‘OUT’ companies.
To see whether a portfolio of ‘IN’ companies would financially outperform one of ‘OUT’ companies, we built a universe of 576 firms, which were all those in the MSCI Europe index that our SRI process recommended as being ‘IN’ or ‘OUT’ between early 2008 and mid-2013. We used this universe to back-test and calculate the absolute, relative and risk-adjusted performance of various cap-weighted (CW) and equally-weighted (EW) portfolios. The risk-adjusted data allowed us to take into account the differences between portfolios.
What was your main conclusion?
As in other studies of SRI performance, we found that one can generate additional financial value by systematically selecting the shares of 'responsible' companies. However, our observations also highlighted the importance of the size of firms in the amount of performance generated. When small firms had larger weights, as in the EW portfolios, the portfolio of ‘IN’ firms generated 291bp of alpha a year, while the portfolio of ‘OUT’ firms lost 83bp of alpha a year. Small and medium size firms are more prone to be neglected and therefore to be less efficiently priced. We also noted that, across all sectors, the Best-In-Class selection favours large capitalisations and seemed to modify the exposures to risk factors such as the Market factor and the Fama-French SMB factor.
In our view, these findings argue for more robust analysis of the extra-financial performance of medium and small-cap firms.
 One of three factors in the Fama and French stock pricing model. SMB accounts for the spread in returns between small- and large-sized firms, which is based on the company's market capitalisation. This factor is referred to as the "small firm effect", as smaller firms tend to outperform large ones.