Meet 125 Mgmt Teams
Long Story Short: Building a Portfolio in an Era of Ethical Investing
Sins of Omission
(Note: companies that could be impacted by the content of this article are listed at the base of the story [desktop version]. This article uses third-party references to provide a bullish, bearish, and balanced point of view; sources are listed after the Balanced section.)
With growing interest in socially responsible investing and corporate awareness of environmental, social, and governance (ESG) issues, should investors shun corporations that are branded “sin” stocks? Typically associated with the alcohol, tobacco, gaming, and firearms industries, the number of sin stocks appears to be growing as investors weigh environmental, human rights, political positions, and other issues into their investment decisions. Should investors be more concerned about earning appropriate risk-adjusted returns rather than making moral judgments? For investors willing to indulge in a little vice, we examine the bull and bear case for four sectors generally left out of socially responsible portfolios.
Sin Stocks Can Be a Source of Positive Alpha. Based on closing monthly prices, the ISE SINdex Index outperformed the S&P 500 during the period October 2009 through October 23, 2019. Some argue that sin stocks may be systematically underpriced because so many are shunned by investors and those willing to invest may earn a reputation risk premium. Others point out that sin industries face increased regulatory and litigation risk for which investors are rewarded. In an article titled “Sin Stocks Revisited: Resolving the Sin Stock Anomaly,” the authors found that, consistent with various studies and existing literature, sin stocks exhibit a significantly positive capital asset pricing model (CAPM) alpha in the US, European, and global samples. However, they found that the performance of sin stocks is fully in line with their exposures to factors such as profitability included in the current asset pricing models, and there is no evidence of a specific sin premium as a reward for bearing reputation risk.
Sin Stocks Generally Benefit from Inelastic Demand for Their Products. Products like alcohol, tobacco, and gambling are generally habit-forming and demand is less susceptible to changes in the business cycle. Absent secular trends, alcohol and tobacco consumption generally remain durable despite economic downturns.
Barriers to Entry. Manufacturers of alcohol, tobacco, and firearms are highly regulated and the regulatory risk along with the threat of litigation may act as barriers to entry that ward off potential entrants. Experience in litigation, regulatory and external affairs, and strong brand identity generally provide incumbents with competitive advantages.
Multiple Options for Investors. Multiple avenues exist for investors to gain exposure to sin stocks, including purchasing company shares, exchange traded products such as Advisorshares Vice ETF (VICE), or mutual funds, including USA Mutuals Vice Fund Investor Class Shares (VICEX). In a US News & World Report article, Jordan C. Waldrep, portfolio manager of The Vice Fund (VICEX) expressed that, “in the long term, vice investing makes sense because these are often well-managed companies with generationally established brands and extremely loyal customers.”
Sin Stocks May Be Undervalued, but They Stay Undervalued. Research suggests that sin stocks may tend to be undervalued because they may be underfollowed by Wall Street analysts and have more difficulty attracting institutional investors. Many are excluded from portfolios on ethical grounds.
Bearing the Stigma. Some believe that investors holding sin stocks can face reputational risk, particularly as the public becomes more polarized and increasingly vocal against industries believed to harm human health such as tobacco, alcohol, and weapons. With investment managers sensing an opportunity to gain assets from a growing segment of socially conscious investors and amassing power to influence winners and losers, one might expect “sin” stocks to be further vilified to enhance the appeal of ethical investing, especially at times when the news cycle causes certain industries to draw negative attention.Regulatory and Litigation Risks. Tobacco, alcohol, and firearms manufacturers are subject to significant regulatory and litigation risk. Regulations at the state or federal level can change and can have material negative impacts on profitability. These can relate to restrictions on sales, advertising, or the imposition of product, health and safety standards. Additionally, litigation risk can be significant and one major loss in court can pave the way for more negative judgments. Lastly, these businesses can be subject to significant taxes at the federal, state, and local levels.
By neglecting companies within certain industries, investors may be restricting their portfolio’s return potential. While socially responsible investing has a place on the spectrum of investments, one should be aware that socially responsible investing funds are not immune from holding equities that may be negatively impacted by corporate malfeasance. For investors more focused on returns and portfolio diversification, so-called “sin” stocks should not be overlooked and may have a place in their portfolio whether through direct investment or owning an index fund that owns all types of stocks.
Sin Stocks Outperform Over Time, Study Says, Forbes, David K. Randall, October 21, 2009
Sin Stocks Revisited: Resolving the Sin Stock Anomaly, Journal of Portfolio Management, David Blitz and Frank J. Fabozzi, Fall 2017, Volume 44, Issue 1.
Research Reveals Why Sin Stocks Outperform, ROBECO, David Blitz, Head of Quant Research, November 9, 2017.
Mutual Funds Investing in Sin Stocks, Investing in Tobacco, Alcohol and Other ‘Sin Stocks’, The Balance, Kent Thune, September 24, 2018.
Why Sin Stocks Are an Investor’s Salvation, U.S. News & World Report, Rebecca Lake, July 20, 2018.