This paper investigates whether fiduciary duty obliges pension fund trustees to invest over-proportionally in ‘sin stocks’, i.e. companies operating in sectors traditionally considered unethical such as tobacco, alcohol, gambling and defence.

The authors postulate that such an obligation would only exist if these sectors are expected to outperform the market in the future. Following analysis of the only investment fund existing worldwide that invests purely in sin stocks (the Vice Fund) they conclude that, all else being equal, neither an existing sin stock investment strategy nor an existing responsible investment strategy are significantly likely to perform differently to a conventional whole market approach.

James P. Hawley, Andreas G. F. Hoepner, Keith L. Johnson, Joakim Sandberg, Edward J. Waitzer (Available from March 2014) Cambridge Handbook of Institutional Investment and Fiduciary Duty

A highly conservative interpretation of fiduciary duty might suggest that trustees of a pension fund are not only unable to ignore certain sectors, but are obliged to invest in any market that is expected to deliver superior financial returns, regardless of any non-investment related impact of that market on the beneficiaries as individuals or on society. This could create a paradox for some pension funds if they were compelled to invest over-proportionally in industries that are considered detrimental to the wellbeing of their beneficiaries from a broader perspective, such as health care companies’ pension funds investing in tobacco or other products that have a negative impact on health. Hoepner and Zeume theorise that this paradox would only exist if sin stocks are expected to outperform other sectors in the future. If these sectors can reasonably be expected not to outperform, then pension fund trustees would be acting within their fiduciary duty if they chose to ignore an over-proportional investment in them, however conservatively this duty is interpreted.

Several academic studies have investigated the historical performance of sin stocks and found evidence for superior returns. Some of this is attributed to these stocks being excluded by some investors due to social concerns, leading to a share price depression. This consequently leads to an abnormally high dividend yield, although Hoepner and Zeueme counter that it should be just as likely to lead to underperformance as investors might not buy into this socially concerning dividend yield. An additional hypothesis is that the outperformance of tobacco stocks can be explained in part by the greater legal and excess taxation risk associated with these products. This would suggest that while the returns may be higher, the risk-adjusted return may be no better than other sectors. There is also some evidence that the size of companies in a sin stock portfolio was more influential than the sectors themselves in previous academic studies, with smallcap stocks outperforming large-caps, since equally weighted sin stock portfolios appear to outperform the market but value-weighted sin stock portfolios do not.

“If ‘sin sectors’ can be expected not to outperform, then pension fund trustees would be acting within their fiduciary duty if they chose to ignore an over-weighted investment in them, however conservatively this duty is interpreted.”

While numerous studies have investigated the performance potential of hypothetical sin stock portfolios, the authors claim that only one real investment fund adopts this strategy worldwide: USA Mutual’s Vice Fund. A previously published analysis of this fund concluded that it has delivered historically superior returns, however, in this study Hoepner and Zeume find that over a longer period, using more recently developed modelling tools, and when controlling for exposure to small-cap stocks and the greater legal and tax risk of the tobacco industry, the Vice Fund does not outperform either a conventional or an ethical benchmark.

Hoepner and Zeueme extend their analysis of the Vice Fund by investigating the skill set of the Fund’s managers, testing their ability to predict the general direction of the equity market and individual assets, as well as their ability to manage the fund through periods of severe market stress. The results suggest that the managers’ investment decisions on each of these factors have reduced the Fund’s performance.

In conclusion, the authors believe their findings shows that the Vice Fund does not offer fundamentally better return expectations, and supports the view that responsible investment strategies including sector exclusions can be compatible with fiduciary duty.

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