phi•lan•thro•py (noun): Desire to benefit humanity; A desire to improve the material, social, and spiritual welfare of humanity, especially through charitable activities
Individual philanthropists, endowments, and foundations alike serve a critical role in a capitalist society. America’s earliest and greatest titans of industry—John Davison Rockefeller and Andrew Carnegie—defined the structure of modern philanthropy. Rockefeller used his considerable petroleum fortune to target causes such as medicine, education and scientific research. Carnegie used his steel fortune to fund libraries, education, scientific research and to promote world peace.
Today, the Bill and Melinda Gates Foundation is the philanthropic vehicle for America’s most recent titans of industry (Gates and Warren Buffett), giving to causes such as medicine, education, and poverty and development. Countless other philanthropists and religious and not-for-profit organizations are committed to filling the gaps in the government’s net, endowing causes as diverse as providing housing (Warrick Dunn Family Foundation), to supporting the arts and land conservation (The Donnelly Foundation), to human rights and the impact of technology (The MacArthur Foundation).
The Hewlett Foundation and others have done significant work to advance the scientific measurement of the impact of a dollar given by an organization. This is known as the Social Return on Investment1, or SROI. Effective measurement of SROI can help build a feedback loop, allowing increased impact per dollar of giving. This is independent of investment performance. Holding the endowment portfolio size (Ep) and SROI of the grant (SROIg) constant, many view relative return as the only remaining impact lever.
No surprise then that many philanthropic groups seek to maximize the relative return of their investment portfolio, subject to maintaining enough short-term liquidity to fulfill near-term giving. Here, the beta, market portfolio, and portfolio alpha are the levers for improving investment return. The benefit of the investment portfolio is often viewed solely as enabling increased giving:
(Ep*βep [E(rm)–rf ] + αef) *SROIg= Impact of Investment on Grant
Ep= size of endowed portfolio
βep = beta of the endowed portfolio
E(rm )= expected return of the market portfolio
rf= risk free rate of return
[E(rm ) –rf ] = equity risk premium
αef = alpha of the endowed portfolio
SROIg= Social Return on Investment for grant
While this is indeed a key benefit of a philanthropic organization’s portfolio, there is a substantial omission in measuring the investment portfolio’s impact: the Pre-Grant Impact of the funds invested prior to targeted giving.
About 5% of endowments and foundations do target a portion of their investment dollars toward Mission Related Investments, or investments which are consistent with and/or advancing a cause. Such investments may include below-market-rate investments, in which the expected rate of return is near-zero. An example of such an investment is making low interest business loans with a substantial risk of default in a low-income section of a given municipality. Here, the opportunity cost in the form of below-market-rate return on investment dollars (via a different market portfolio and lower expected alpha) is offset by the philanthropic return of positive societal impact of the investment portfolio prior to giving, as indicated by the Pre-Grant Impact shown below:
SROIep= the SROI of the endowed portfolio while invested
E(rmbi ) = expected return of the mission-based investment market
αmbi = expected alpha of the mission-based investment portfolio
(Ep*SROIep ) = the impact prior to grant, and is expected to be positive
(Ep* (βi [E(rmbi ) – rf ] + αmbi ) = investment return, expected to be near-zero
For market-rate investments, the total incremental impact equation remains the same. As the name implies, the expected investment return on this portfolio is expected to be substantially higher than that of a below-market-rate portfolio. In this scenario, however, there is a negative SROI on the endowed portfolio while invested, given the investments in companies such as alcohol, tobacco, and gaming companies and the negative externalities associated with their products:
(Ep*SROIep ) = expected to be negative
((Ep* (βi [E(rm ) – rf ] + α) *SROIg ) = expected to be positive
Most all religious endowments use some form of socially-responsible investing (SRI). SRI traces its roots back to centuries-old religious beliefs. Restricting purchase of stock in tobacco, alcohol, abortion, gaming, and military and defense companies are pervasive “social screens” for these endowments. Endowments and foundations may have negative screens of their own; not owning tobacco stocks is commonplace. Others won’t own stock of military and defense companies, or companies that derive revenue from Sudan. This implementation of social screening curbs the negative SROI of the endowed portfolio while invested, increasing the Pre-Grant Impact. However, it has given rise to the main concern about “socially-responsible investing” for some philanthropic organizations in the US:the fear that the screened investment universe will result in lower returns, resulting in a lower Impact of Investment on Grant. Due to this concern, many view such portfolios in this form:
SROIssep= SROI of socially-screened endowment portfolio, which is greater than the expected
SROI of the unscreened endowment portfolio
(Ep *SROIssep ) = expected to be zero;
E(rssm ) = expected return of socially-screened market portfolio
αssep= alpha of socially-screened investment portfolio, which is less than the expected alpha of the unscreened endowment portfolio
((Ep * (βi [E(rssm ) – rf ] + αssep ) *SROIg ) = expected to be positive, but less than the expected impact of the unscreened endowment portfolio
In reality, eliminating investments in companies deriving more than 5% of their revenue from alcohol, gaming, tobacco, military & defense, or companies involved with The Sudan (as measured by KLD Research & Analytics) would only limit the large-cap investment universe by about 5-7% as measured by market cap2, and has minimal impact on expected total return3. The majority of active equity strategies employ some type of investment screen (for example, not buying stocks at above average valuation multiples), and often these screens are far more restrictive. These managers would argue they are simply eliminating candidates they deem likely to underperform.
These negative screens, while still relevant for certain philanthropic and religious portfolios, are taking a backseat in the rapidly evolving world of sustainable, responsible investing. Environmental, Social and Governance information—commonly referred to as “ESG”—is a rich, rapidly improving field of research and information for investors, and this ESG information is critical for philanthropic groups looking to maximize their total impact.
Earlier, we referenced the substantial breadth of causes targeted by philanthropic groups.
Including such considerations not only curbs the negative impact of the investment portfolio, but also carries real benefits in the form of altering capital costs for a broader swath of public companies. Wide-scale incorporation of ESG considerations will translate into companies with poor operating practices facing substantially higher capital costs, while the best operators should see reduced capital costs. In fact, a portfolio tilted towards companies with the best ESG practices significantly increases the SROI of the endowed portfolio by altering the cost of capital for firms:
SROIesgep = SROI of ESG-integrated endowment portfolio, which is greater than the expected SROI of the unscreened or socially-screened endowment portfolio
(Ep * SROIesgep ) = expected to be greater than zero
E(rnsm ) = expected return of ESG-screened market
αnsep = expected alpha of ESG- integrated investment portfolio
((Ep * (βi [E(resgepm ) – rf ] + αesgep ) * SROIg ) = expected to be positive, but feared to be less than the expected impact of the unscreened endowment portfolio
There are substantial risk benefits to incorporating Environmental, Social and Governance information. Anecdotally, it’s easy to understand why investments in companies with poor environmental, social and governance practices are more risky. A company with poor environmental practices may face substantially higher capital expenditures as the government continues to tighten emission standards. In the event of an environmental accident, such a company will face substantial containment, clean-up and reparation costs. A company employing child labor or placing workforce in high-risk environments, whether directly or in the supply chain faces a substantial risk of consumer boycott and subsequent revenue loss. Finally, a company with a poor governance structure may be more susceptible to untoward or downright fraudulent activity. In each of these instances, the companies may be burdened by higher future litigation costs.
The risk story isn’t solely anecdotal, however. Research has shown that not only do companies which rank poorly along ESG lines demonstrate substantially higher return volatility4, but also that the return volatility is heavily skewed5. As measured by ESG, poorly rated companies have a higher propensity for extreme negative outcomes.
Much like in the case of social screening of certain activities, there’s concern about the potential for negative impact on return for incorporating ESG information into stock analysis and portfolio construction. “Demystifying Responsible Investment Performance”, a Mercer Consulting and UNEPFI review of 20 academic studies reveals only 3 show a negative relationship between ESG factors and portfolio performance. The same study details a review of 10 brokerage reports which reveals none show a negative relationship between ESG factors and portfolio performance. Further evidence that SRI assets have increasing and significant impact on stock returns is contained in a 2007 working paper from the Federal Reserve Bank of Atlanta6. Watson Wyatt and Russell have also issued supportive studies7,8.
Ultimately, then, the fully-integrated ESG portfolio has both a better Pre-Grant Impact and an Impact of Investment on Grant which is equal to or better than that of a market-rate portfolio, and better than a market-rate portfolio when the volatility and tail risk of the investments is considered.
SROIesgep = SROI of ESG-screened endowment portfolio, which is greater than the expected SROI of the unscreened or socially-screened endowment portfolio
(Ep * SROIesgep ) = expected to be greater than zero;
E(rnsm ) = expected return of ESG-screened market, expected to be equal to an unscreened market
αnsep = expected alpha of ESG- screened investment portfolio
((Ep * (βi [E(resgepm ) – rf ] + αesgep ) * SROIg ) = expected to be as positive as a non-ESG portfolio, and better on a risk-adjusted basis
It’s critical that the investment advisor and consultant work to build a deep understanding of the endowment or foundation’s mission. The optimal ESG-integrated investment portfolio can and should accentuate the specific interests of the philanthropist. While preferable to a portfolio which disregards ESG issues, a one-size-fits-all approach to ESG incorporation will fall short of ideal. Failure to include ESG information results in a less-comprehensive analysis at the security level, a sub-optimal investment portfolio, and less-than maximum impact for the philanthropists’ respective missions.
1. SROI Project. January 27 2011. < http://www.sroiproject.org.uk/>.
2. The Impact of Negative Screening, FA Magazine. January 27 2011. < http://www.fa-mag.com/component/content/article/14-features/5161.html?Itemid=131>.
3. A Quant’s Take on ESG, Responsible Investor Magazine. September 17 2009. < http://www.responsible-investor.com/home/article/quant/>.
4. Reducing Portfolio Risk Through Sustainable Investing, Advisor Perspectives. November 16 2010. < http://www.advisorperspectives.com/newsletters10/Reducing_Portfolio_Risk_through_Sustainable_Investing.php>.
5. The Impact of Negative Screening, FA Magazine. January 27 2011. < http://www.fa-mag.com/component/content/article/14-features/5161.html?Itemid=131>.
6. Becchetti, L., Cicretti, R. & Hasan, I. (April 2007), Corporate Social Responsibility and Shareholder’s Value: An Event Study Analysis, Federal Reserve Bank of Atlanta Working Paper 2007-6
7. Goodland, Jane. Investing for the Future, Watson Wyatt, 2007
8. Collie, B. & Myers, H., “Responsible Investment: Five Tests of an SRI/ESG Policy”, Russell Research, August 2008
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