The Original Impact Investing: Faith-Based Funds, Factor Tilt or Marketing Ploy?

Faith-based funds were founded in the past few decades by a wave of social-financial entrepreneurs to help religious folks, a group who has struggled to find belonging in the capital markets, navigate financial markets. These companies have increased their assets under management (AUM) by over 33% in the past five years; this while AUM for active managers as a whole have declined. Moreover, the returns of these church-going, Shariah-compliant investors have outperformed their benchmarks year-to-date by over one-thousand basis points (ten percentage points) in some cases.

Institutional investors looking for the next outperforming factor might just need to take a leap of faith.

But questions remain whether faith-based investment strategies are as differentiated as they say they are from traditional, secular strategies. The debate rages whether faith-based strategies act under their fiduciary responsibility to the client to provide a values-based approach to stewardship or if they purely focus on maximizing returns; moreover, if faith-based investing even provides actual alpha over their benchmarks or whether it actually take on more risk because their holdings are less diversified. These social-financial entrepreneurs could just be wolves in sheep’s clothing selling snake oil to gullible investors.

Ultimately, finding answers to these questions might give us a deeper understanding of other forms of mission-focused, values-based, impact investing strategies that have captured the attention of the world. Professor Cleveland Justis, who teaches Social Entrepreneurship at Berkeley-Haas School of Business, says that impact investing is at the forefront of social entrepreneurship — shaping both the future of social enterprises and social financial entrepreneurship.

This topic hits at the core of what social entrepreneurship is and its limitations thus far.

If “Social Entrepreneurship is an[y] innovative, social-value-creating activity,” according to Jane Wei-Skillern, a Senior Fellow at the Berkeley-Haas School of Business, what does the data tell us about the social-value-creating impact of faith-based investing?

Potential Positive (Unintended) Consequences of Social-Financial Entrepreneurs

First, a little history.

Faith-based investing was the original impact investing. Its roots stem from the colonial era when Quakers and other puritanical sects sought a way to align their stewardship with their values. Since then, faith-based investment managers have increased their assets under management to $28 billion across 150 funds, according to InvestmentNews.

These funds have done good for their investors over the past year.

Ave Maria Rising Dividend Fund (AVEDX), which claims to invest in high-dividend-yielding businesses that are Pro-Life, has increased 21.73% year-to-date. The equivalent benchmark tracked by Lipper was up only 11.9% year-to-date, according to Investment News.

Amana Growth (AMIGX), a fund that invests in Shariah-Compliant businesses, was up 29.8% this year, the top performer on Morningstar’s list of best-performing Shariah-Compliant Funds.

Source: Saturna Capital

Saturna Capital, an investment company that manages both secular mutual funds and those adhering to Sharia Law, reported a $484 million increase in assets in fiscal year 2019 with 95% of that increase coming from investments following Islamic principles, according to Saturna’s 2019 Annual Report. This more than 10% increase in assets under management follows a year of significant outperformance on the part of Saturna’s four Amana funds.

This increase in assets under management also benefits from larger, secular trends. According to PwC, “Perhaps the single most important factor behind the powerful growth of the Shariah-compliant funds industry lies in the simple fact that Muslims represent about a quarter of the world’s population,” yet less than 1% of financial assets are Shariah-compliant. As young Muslims in developing countries begin to save, Shariah-compliant funds have the potential to grow between 15–20% a year.

The Stickiness of Faith-Based Assets Despite Longer-Term Underperformance

At a cursory glance, the outperformance is justified. Companies that are values-oriented have a good rapport in the communities they operate, which reduces employee turnover and increase ability to execute on strategic change and make long-term investments. When constituent companies outperform, funds with a larger percentage of their portfolios invested in these stocks also outperform — in theory.

Source: Maks F. S.

Faith-based funds have actually underperformed their benchmarks over the past decade. Amana Growth (AMIGX), the biggest outperformer on Morningstar’s list of Shariah-compliant funds last year, has lagged the S&P 500 by 150 basis points (1.5 percentage points) per year over the past 33 years. Cumulatively, that 1.5 percentage point underperformance has cost its investors $860 for every $100 invested over the 33-year life of the fund.

In an industry as cutthroat as investment management, the Amana funds are just one example of the stickiness of faith-based assets. In periods of outperformance, faith-based assets attract capital. In periods of underperformance, faith-based assets rarely decrease in assets for two primary reasons: 1) faith-based investors are typically retail investors who are “less-sophisticated,” and 2) advisers and managers are able to explain away the underperformance as the cost of being missions-oriented.

“If people are really interested in faith-based investing, a difference of 10 or 12 basis points is not that much if you’re avoiding things you don’t want to invest in,” said Shane Morrow, managing partner at IronBridge Wealth Counsel, an advisory firm that offers clients “mission-driven” portfolios alongside traditional strategies.

The second reason is more pernicious because a couple basis points of underperformance snowballs into a lot of money over these investors’ investment horizons. Moreover, there is reason to believe these funds aren’t even delivering on the mission they’ve set out to do.

Measuring Mission Execution and Impact is Tough

Impact investing is about aligning values and investment decisions. It’s about constraining the investment universe to businesses that adhere to a certain mission. In faith-based investing, that social mission is supposed to align with the values and principles of that faith.

The mechanism by which these funds follow a missions-focused investment strategy can be as simple as excluding certain “sinful sectors” from their investable universe and as complicated as creating proprietary scores for certain principles, such as usury, likeliness to support the sale of pork, and manufacture and support alcohol consumption. Herein is where I have problems.

To what degree does a company’s faith-adhering actions outweigh that company’s investment merit? Many funds won’t invest in Apple because its CEO is gay or American Express because they briefly changed their logo to rainbow colors for Pride Week. Taking this “degree question” to its ultimate extreme, some people will make the argument that just buying U.S. treasury bonds supports certain national political agendas in conflict with non-Christian values — LGBTQ lifestyle, abortion, divorce rights, etc. Who determines what is biblically responsible or Shariah-compliant and what is not?

Furthermore, who is enforcing whether fund managers immediately sell their position in a company that does something “non-Christian”, even if the company is still cheap, profitable and beneficial for the client to own? Perhaps making these decisions is what the fund manager gets paid to do. However, I’m skeptical of their actual ability and/or purpose in doing so.

Second, the fees for investing in a faith-guided fund are perhaps 90–100 basis points higher than investing in a passive index fund. The Human Rights Campaign has an annual Corporate Equality Index (CEI) that rates how progressive and sensitive 851 public companies are to LGBTQ lifestyle. A score of 100 means that a company is sensitive to LGBTQ people, and an index of less than 30 means that a company isn’t doing enough for LGBTQ people.

For faith-based fund managers, an easy way to find eligible investments could be to just buy those companies that are well-capitalized (so they aren’t at risk of bankruptcy) and have a CEI of less than 30.

Source: A Trivial Knot

I found companies that scored above a 70 CEI that these managers overweighted like Costco, which the Huffington Post reported was the LGBT community’s best-perceived brand, and Honeywell, which the Human Rights Campaign called one of “The Best Companies for LGBT Equality”.

In the majority of cases, personally, I couldn’t find a second reason for owning the companies that these managers had bought for if it wasn’t because of their low CEI rating. Back-testing several firms, I found a large correlation between low CEI rating and large weighting in Biblically-Responsible Investment (BRI) funds. If managers are merely buying companies on the Human Rights Campaign list — without doing very much extra work finding value for their unitholders — I see no reason why investors should be paying extra management fees for these managers that often lag their benchmarks.

If you believe Milton Friedman, the only direct responsibility companies have is to earn a profit for their shareholders. In this pursuit for profits, the company may find it advantageous for its brand name, recruiting prospects or their customers to invest and foster positive community values. A company with absolutely no moral values will destroy the community that it serves, erode its customer base and ultimately destroy shareholder value (think Vale or BHP Billiton in the Samarco dam debacle).

Thus, the best option for companies is to make large investments in the communities they operate in and care for their customers. This just sounds like good business sense. However, most companies cannot choose the community nor the culture in which it operates.

The company must therefore contribute to the community in ways that do not offend any specific demographics nor divide the community. For small companies, this public scrutiny is negligible; however, for larger companies — with many operating markets, thousands of diverse employees and a need to maintain strong company-wide codes of ethics — they cannot selectively support or undermine certain causes.

It is important to note that small companies who want to become large companies are also best advised not to offend their customers. Most companies cannot be partial to a certain religious perspective if they’re large businesses with representative workforces. Chances are then that these companies overextend many religious principles that faith-based fund managers say they try to screen out. What product are these faith-based managers actually peddling if the investments they make don’t ultimately screen out these companies?

Moreover, having scanned the top holdings of many of these outperforming faith-based funds, I noticed that more than 50% of their holdings are in technology and healthcare stocks. The largest holdings are Apple, Amazon, Google, and Qualcomm. Most people can find instances of official company policy from all of these businesses that contradict both Christian and Halal principles.

Source: Great Lakes Advisers

Broadening the Scope: Impact on Impact Investing as a Whole

Secular millennials and hippy-types alike have caught wind of a missions-based approach to stewardship. Companies like Fidelity, Pax World Fund and T. Rowe Price have cropped up to service the demand. These market their funds to investors as financial products that only invest in businesses that rank highly on ESG (Environmental, Social, Governance) scores. ESG-focused funds, similar to Faith-based funds, are funds created to address a social issue or create social value for certain groups.

The problem, as we explained above, is measuring a company’s ESG execution is difficult. Nevertheless, assets under management at ESG-focused funds recently surpassed $12 trillion dollars, which towers over the $28 billion invested by ESG’s more conservative cousins.

In addition to mutual funds, companies like Orthogonal, which has the stated mission of only investing in companies that benefit people and the plane; Ellevest, which is an investment platform designed to invest in and for women; and, Acumen, which is investing in companies that will change how the world tackles poverty are also capitalizing on the broader awareness and willingness to invest but invest responsibly.

ESG funds have also outperformed in recent history; however, that outperformance perhaps comes from a concentration of risk in new-wave, technology companies, which have the cash flows and employee momentum to institute ESG-friendly policies.

This could lead investors in ESG funds to experience the same long-run underperformance as investors in Faith-Based funds have experienced. Moreover, the concentration of risk is concerning given the increased political pressure on tech companies to pare down their often monopoly-like statuses.

Conclusion

Faith-based funds, in many ways, have defined how we understand impact investing for social benefit.These social-financial entrepreneurs have started businesses that have thrived, while their clients have not. While these funds have outperformed their benchmarks in recent history, they have significantly underperformed benchmarks over the past ten years. For investors sympathetic to a missions-based approach to stewardship, the long-run is all that matters. Faith-based AUM has grown significantly because the nature of a dual-mandate approach to investing means that the non-financial mandate serves as a marketing ploy during good years and often an excuse for underperformance in bad years. For a whole host of measurement and execution problems, faith-based investing portends similar long-run underperformance on both their mission and financial mandates to investors. As impact investing increases in academic and empirical presence, the public will have to brace itself for an onslaught of social entrepreneurs and charlatans alike peddling these missions-based investment opportunities.

Approach these opportunities with caution and skepticism.