Mark Gilbert is a Bloomberg Gadfly columnist covering asset management. He previously was a Bloomberg View columnist, and prior to that the London bureau chief for Bloomberg News. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”

It seems logical that so-called ethical investing comes at a cost. If an investment fund restricts the universe of shares it's willing to buy for good moral reasons, it's likely to miss out on some stellar opportunities. But what if those lower returns are actually a desirable consequence of environmental, social and governance policies, rather than an unhappy side-effect of investing with a conscience?

That's the argument made by Cliff Asness, the billionaire co-founder of AQR Capital Management, which oversees more than $180 billion. In a report earlier this month, he made the case that lower returns are a necessary condition of adopting ESG constraints:  

If the virtuous decide they won’t own something, the sinners then have to, and they have to be induced to through getting a higher expected return than otherwise. This in turn is achieved through a lower than otherwise price.

That lower than otherwise price in turn raises the cost of capital for the sinful company, which translates into a higher discount rate when the company is evaluating expansion and investment. That, Asness says, is how ESG policies achieve their objectives:

If the discount rate used by sinful companies isn’t higher as a result of constraints on holding sinful stocks then there was no impact. And, if the discount rate on sin is now higher, the sinful investors make more going forward than otherwise. If the virtuous are not raising the cost of capital to sinful projects, what are they doing? How are they actually affecting the world as they wish to?

So that's the theory. How does it work in practice? Norway's sovereign wealth fund is being urged to stop investing in banks that lend money to the palm-oil industry, which is accused of deforesting Asia and elsewhere. By using its clout to influence those who finance damaging industries, the fund would be making explicit something already embedded in ESG policies -- not only punishing undesirable behavior by withholding investment from it, but curbing it by raising its cost of capital and making the behavior economically less efficient.

A report this week from Rainforest Foundation Norway and the Fair Finance Guide calls for Norges Bank Investment Management to disinvest from seven banks in Indonesia and Singapore that back palm-oil production with $12.5 billion of loans. The fund had abandoned direct investments in 29 palm-oil producers between 2012 and 2015 because of the industry's role as "a major contributor to tropical deforestation."

In the context of NBIM's $950 billion of global investments, the amounts involved in the palm-oil financing institutions are tiny. Even the biggest holding among the seven banks is worth just a bit more than $600 million (in DBS Group Holdings Ltd., the Singaporean parent company of DBS Bank Ltd.) But even that gives the fund a significant stake in the lender.

What's at Stake
How much Norway's sovereign wealth fund owns, plus percentage of shares held
Source: Norges Bank Investment Management website

The Norwegian fund's explosive growth -- it's quadrupled in size since 2009 -- has made it a major investor in the world's equity markets, in turn giving it a growing influence over the companies in which it invests.

A Force to Be Reckoned With
Norwegian sovereign wealth fund's total holdings by region
Source: Norges Bank Investment Management website
Note: Figures are based on the fund's holdings relative to the FTSE Global All Cap Index's market value.

As its disinvestment from the palm-oil industry in recent years shows, the fund tries to be a force for good. It excludes tobacco makers, as well as some weapons manufacturers and companies guilty of "severe environmental damage." Last year, it added "unacceptable greenhouse-gas emissions" to the list of crimes it won't help fund, as well as excluding companies dependent on thermal coal for one-third or more of their businesses.  

Based on the argument advanced by Asness, the fund's ESG policies should penalize its returns. Helpfully, NBIM calculates what its conscience has cost it in its annual report on returns and risks.

The Cost of a Conscience
Impact on Norwegian sovereign wealth fund's equity returns of excluding certain investments
Source: Norges Bank Investment Management website
Note: Both product-based exclusions (weapons makers, tobacco companies, thermal coal producers) and conduct-based exclusions (e.g. environmentally damaging or human rights violators) are included

Clearly there are years when shunning some industries actually benefits the fund; avoiding companies that are dependent on thermal coal, for example, can be a winning as well as an ethical strategy when the industry as a whole is in a share-price funk.

The cumulative effect of those ethical exclusions is clearly having an impact on returns, however. The fund calculates that product-based exclusions have cost it almost 1.9 percentage points in the past decade.

So not only should conscientious investors be resigned to accepting lower returns, they should arguably welcome them as evidence that their morality is having a concrete impact. But I'll leave the final word on the issue to Asness:

Frankly, it sucks that the virtuous have to accept a lower expected return to do good, and perhaps sucks even more that they have to accept the sinful getting a higher one. Well, embrace the suck, as without it there is no effect on the world, no good deed done at all.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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Mark Gilbert in London at

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