Jina Penn-Tracy, co-founder of Centered Wealth, discusses her new research suggesting that socially responsible investing can improve investor returns by changing investor behavior.

Morningstar’s 2018 "Mind the Gap" study, which measures the performance of the average dollar invested in a fund and estimates the effect investor behavior had on investment outcomes, reports a 0.26 percent gap between U.S. open-end funds’ returns and investor returns. The good news is that this is the lowest performance gap in a decade. But the gap widens in more volatile times—the 2014 "Mind the Gap” reports a 2.49 percent difference for the 10-year period ending with 2013. This means investors are missing out on additional savings in their retirement portfolios, a cause for concern for financial advisors.

So can a focus on sustainable and impact investing make a difference in closing this performance gap? Jina Penn-Tracy, co-founder of Centered Wealth in Minneapolis, says yes, and has the data to back it up: “In our latest study we find it makes a remarkable difference in returns: over 10 years the largest difference we see is between a traditional value fund investor and a socially responsible investor, with an improvement up to 1.23 percent in the return seen by the socially responsible investor—and this increase is due to investor behavior.”

I met Penn-Tracy two years ago at a sustainable and impact investing conference in New York when she was just starting the research project. I was intrigued because the study was using behavioral economics to look at the performance gap. Now that the study results are in, I asked Penn-Tracy to share some of the key findings and how they can help financial advisors close the gap for their clients.

The Study

Penn-Tracy’s focus on sustainable and impact investing began more than 15 years ago after a career in traditional financial services. In 2017, with co-founder Stuart Valentine, she started Centered Wealth in Minneapolis. Her interest in the performance gap came during the 2008 financial crisis when she noticed that her clients weren’t reacting the same way as those of her colleagues. “My clients tended to stay invested,” says Penn-Tracy. “We rebalanced, but they were willing to stay the course throughout the decline better than the average investor.”

Her clients’ behavior coupled with research from Morningstar on the performance gap led her to ask the questions: “Do people invested in sustainable, impact or ESG strategies behave differently than traditional investors? And does that difference affect returns?”

To answer those questions Penn-Tracy partnered with Derek Horstmeyer, assistant professor of finance for the School of Business, George Mason University, to crunch the numbers. Horstmeyer used investor data from Morningstar over a 10-year period (2007-2017). He compared the Return Gap on 864 mutual funds with stated SRI or impact focus to the Morningstar data set on traditional funds.

The Performance Gap: It’s All About Timing

As Penn-Tracy suspected when she asked her research questions, the study shows that the difference in returns between the two groups of investors came from timing: Sustainable and impact investors tended to hold steady during market fluctuations.

As advisors we aren’t always successful when we caution clients against buying when the market is high and panicking when the market drops. Penn-Tracy explains that sustainable and impact investing supplies the missing piece in the traditional advisor client relationship. “What we’re seeing is that if you incorporate clients’ values and what they care about into the investment process, they see their investments as an expression of those values,” says Penn-Tracy. “They react less to external market triggers and become more resilient investors.”

In fact, the study shows sustainable and impact investors most resemble passive investors. “The only group of investors that performed better in the face of market ups and downs were passive investors,” says Penn-Tracy. “And we think this is because passive investors are often inside 401K retirement accounts that are mostly invested and then left there.” Interestingly, sustainable and impact investor behavior is even better than that of institutional investors.

Penn-Tracy also points out that the study data included a sustained period of growth and low volatility in the markets. Although some high volatility was captured in 2008, for the most part the extended period of growth leading to a tightening of the performance gap suggests that investors might have become complacent. “What will happen,” Penn-Tracy asks, “when we have future market volatility?” This is where behavioral economics comes in.

Using Behavioral Economics To Understand Client Behavior

Behavioral economics uses psychology and decision theory to study the economic decision-making of individuals and institutions. One of the most significant concepts is how often people make even critical decisions irrationally. Penn-Tracy believes behavioral economics can help advisors better understand why clients sometimes make decisions that affect them negatively even when advisors support them to take a more rational approach to managing their investments. During our interview, Penn-Tracy focused on three key concepts advisors can use in building stronger relationships with clients:

Herd behavior: As individuals we tend to mimic the actions of a larger group, whether they’re rational or not. “We buy when we see the market has been going up and we feel we’re being left out,” says Penn-Tracy. “We feel we have to get in and match the return our neighbor is getting. It’s just normal human behavior but it works against us overall.” Sustainable and impact investors, on the other hand, tend to be more intrinsically motivated. They focus on issues that matter to them in addition to financial performance. As Penn-Tracy puts it, “We’re seeing that ESG and impact investors are internally motivated to stay invested, to stay the course.”

Loss aversion: People tend to be more afraid of losing than attached to winning. In investing, this can mean clients are more afraid of losing money than they are attached to gaining money, and therefore tend to make decisions based on fear. Penn-Tracy explains how sustainable investing can turn loss aversion into positive behavior: “What happens is that clients who are concerned about other issues, like climate change, for example, might fear loss of the ecosystem, or animal species. So that works to keep them invested in their ESG-focused investments rather than jumping out when the market has a downturn.”

Recency bias: Habits make life easier, and we tend to make decisions based on what’s happened most recently. This can play out in the markets, for example, when investors equate any significant downturn with the 2008 financial crisis. Decisions based on this assumption can result in selling at the wrong time. Penn-Tracy explains that sustainable and impact investors exhibit a different kind of recency bias. Important events in society or in the news can prompt people to move their money into ESG and impact funds: “After the Parkland School shooting, a group of investors came to me and asked, “What are we doing about weapons investing? Am I invested in companies that make these weapons?’” So rather than focusing solely on returns, these investors are looking at a bigger picture.

Having The Values Conversation

During our conversation, Penn-Tracy and I talked about the growing use of ESG metrics as part of risk analysis. She’s clear, however, that just having a risk conversation with clients isn’t going to engage them emotionally in a way that’s going to change their behavior: “As an industry, we need to stop pretending that emotions don’t matter and that deep convictions and values don’t matter,” says Penn-Tracy. “We need to talk to clients about what’s meaningful for them: What kind of world do they want for their grandchildren, their great grandchildren? Because when they engage deeply in those internal values and we match their investment with those values, that’s what creates investor resilience.”

Penn-Tracy suggests several ways advisors can get started having these conversations: First, get a good idea of what matters to your clients. Then match the portfolio strategy with their personal values. Walk them through each part of the portfolio, explaining how each investment reflects their values. During regular client meetings, share stories that let them know what different investments are doing on their behalf—successes as well as failures.

For example, Penn-Tracy says her clients respond very positively when she tells them how As You Sow, non-profit leader in shareholder advocacy, filed resolutions with Abbott Laboratories from 2013 to 2015 requesting that the company introduce non-GMO Similac infant formula. Shortly after the 2015 annual meeting, Abbott introduced the first non-GMO Similac products; in the years since, it has become a large and very successful product line. These kinds of stories also powerfully illustrate how shareholder activism works and keep clients engaged in the big picture. “This process makes me a better investment advisor,” shares Penn-Tracy, “because I’m also managing my own emotions and behavior.”

One of the biggest benefits for advisors is that clients stick with you during periods of high volatility. “My clients listen to me,” explains Penn-Tracy, “because I’m relating at that deeper level. So, of course we rebalance portfolios based on these fluctuations and other risk factors happening in the market, but I have relationships that let us get through these cycles together rather than the market breaching the relationship.”

“I put it this way to my clients,” concludes Penn-Tracy. “If we care about what we’re investing in and about making a difference in the world, whether that’s renewable energy, gender equity, clean water or any of the issues sustainable and impact investing focuses on, we’re more able to ride the waves up and down in the market without becoming too reactive. And it’s ironic that the less we focus on financial returns, the better decisions we make and the better returns we get.”

Paul Ellis founded Paul Ellis Consulting to work with financial advisors who want to integrate sustainable and impact investment strategies for their clients.