Researchers Find Surprising Financial Benefits in This Strategy

“We find these effects are especially pronounced for long-term common owners that are locked into portfolios for multiple years,” argues Dartmouth’s Mark DesJardine.

Illustration by II

Illustration by II

Corporate social responsibility is now table stakes for corporate America. But can the efforts translate into returns for investors?

Three professors seem to think so.

In a report titled A Rising Tide Lifts All Boats: The Effects of Common Ownership on Corporate Social Responsibility, authors Mark R. DesJardine from Dartmouth College, Jody Grewal of the Rotman School of Management at the University of Toronto and Kala Viswanathan from Harvard Business School, delve into how a company’s CSR efforts can create a positive domino effect that ripples to peers, multiplying investment returns. The researchers also show how its irresponsibility may have the opposite effect.

The report sought to answer an important question: How can common owners — that is, investors that own shares in two or more companies within the same industry — use their unique boundary-spanning ownership positions to enact strategies that maximize their portfolio returns?

What the authors propose is a simple yet often overlooked strategy in which asset owners impel companies to adopt practices that minimize negative externalities and also have the power to create “spillover” benefits for peer companies in their portfolios.

One of the biggest challenges that investors now face is managing systematic risk – the risk inherent to a market or industry. These risks are a particular concern for investors in index funds. One company’s bad actions, which may negatively affect an entire industry, would have a far greater impact on allocators that own a broad swath of holdings in that sector.

“… one firm’s carbon emissions can especially harm common owners by increasing the climate risk among multiple other firms in their portfolios,” the paper stated. “Since further diversification is infeasible and ineffective for managing systematic risk, common owners need more novel strategies to enhance their risk-adjusted returns.”

The paper referenced a stakeholder theory, which views CSR through an insurance-based lens in which socially responsible actions can earn the goodwill of stakeholders amid negative events and thereby mitigate firm risk.

“Therefore, compared with non-common owners, common owners more highly value — and are more likely to push for — investments in CSR that produce limited benefits for a single firm (e.g., a small reduction in firm-specific risk) as long as they enhance the aggregate value of other industry peers in the investor’s portfolio (e.g., a large reduction in systematic risk),” the paper stated.

These asset owners, according to the authors, may accept and even cause losses for some portfolio companies if they can determine that those losses will be outweighed by gains at other firms.

But how it that measured? Largely, it has to do with perception.

For one, a single firm’s CSR efforts can influence how shareholders engage with peer firms by altering their perspective.

“Attributions occur between firms in the same industry because audiences tend to categorize firms in an industry together. Stakeholders — the media, customers, investors, and others — therefore tend to generalize a single firm’s (ir)responsibility to other firms in the industry,” the paper stated.

In essence, it is rooted in behavioral patterns in which stakeholders “act based on perceptions, not objective reality.” It leads investors to make certain attributions within a particular industry and influences their engagements with other peer firms’ approach to CSR, both in terms of positive (which reduce systematic risk) and negative responses for irresponsible actions (which exacerbate it), according to the paper.

“The key point is if it’s going to work, then the investment return gets that much more promising when you own at least a couple other companies in [the same] space,” DesJardine, who is an associate professor of strategy and management in the Tuck School of Business at Dartmouth College, told Institutional Investor. “And then you can still capture that same benefit at that local company but you’ve just allowed yourself to capture those spillover benefits, which are just a no-brainer.”

But if CSR is used simply as a marketing tactic, those too will be exposed within the industry, and remain on the radar especially for asset owners who are in for the long haul.

“When that stuff is exposed, say, [a company does greenwashing,] there’s enough watchdogs in the long term and it’s going to be uncovered. So we find these effects are especially pronounced for long-term common owners that are locked into portfolios for multiple years,” DesJardine said.

To put it succinctly, asset owners have the power not only to benefit society through CSR, but due to their exposure to systematic risk, they can call on and help firms internalize their externalities when governance and regulators fail to do so.

“Without incentives to see the bigger landscape, some firms will myopically advance their own agendas at the expense of all others in a ‘tragedy of the commons,’ he report stated. “By having to account for the impact of each firm’s actions on the larger system, common owners can incentivize firms to internalize their externalities.”