An Investment Strategy Based on Impact

Impact investment strategies traditionally use either environmental, social, or governance (“ESG”) responsibility measures, as well as financial performance, to choose firms to form a portfolio. In this paper, we integrate the empirical association between corporate social responsibility and tax avoidance into an impact investment strategy.

Impact investing is defined as investments made with the aim to generate positive, measurable social and environmental impact alongside a financial return. According to Global Impact Investing Network, the aggregate impact investing assets under management increased from $502 billion in 2019 to $715 billion in 2020; the COVID 19 pandemic has also accelerated investing in this area. In the US, funds that focus on ESG have gained popularity with investors in recent years. However, despite efforts and calls by regulatory bodies, such as the Financial Reporting Council, for consistency and reliability in ESG reporting and disclosure, it remains a challenge for investors and the public to identify the truly sustainable companies and financial products from those that engaged in “greenwashing”.

Previous studies investigate the relation between corporate social responsibility (“CSR”) and firm performance, and find a positive relationship via the channels of building up social capital and trust; gaining stakeholder support; motivating employees leading to employee satisfaction; lowering cost of capital; lowering idiosyncratic risk and the probability of financial distress; or generating a reputation effect that may have an impact on valuation.

There is no standardization of reporting of CSR activities by firms. Rating agencies use firm disclosures, media reports, news items, surveys, and interviews to collect data to formulate a score that is used to measure CSR performance. This is known as the ESG score and it represents ESG actions and activities of a firm. Previous studies use ESG measures to analyse the impact of CSR activities on the firm’s performance. We posit that an impact investor would select firms that belong to the high ESG category, as these firms are thought to be socially responsible. Despite the widespread use of ESG scores as a measure, studies have criticized the usage of the ESG measures because of the lack of global and standardized ESG reporting. Due to the inconsistency of the ESG scores, it is challenging for investors to use this score as a reliable measure to select responsible firms for impact investment purposes.

Following the strand of literature that documents a close association between CSR and tax avoidance, this study proposes another measure to assess the social responsibility of a firm, which is tax avoidance (“TA”). This measure can capture the ethical and social responsibility dimensions of a firm in terms of paying corporation taxes that can lead to huge societal implications. In other words, an impact investor can evaluate if a firm behaves responsibly by making certain it has a high ESG score and low TA. Additionally, impact investors could use this measure as an investment criterion in impact investing.

Corporate tax avoidance has not gone unnoticed by the public and politicians. There are initiatives in the US and the UK for companies to pay a ‘fair share’ of the profit made by revenues earned in that jurisdiction. The proponents of these initiatives hope that they will result in curbing international tax avoidance and profit shifting .

Tax avoidance refers to minimization of the tax liability within the framework of the law. However, when firms indulge in excessive tax avoidance behavior which is not in the ‘spirit’ of the law, it may be viewed as unethical or socially irresponsible. Previous literature documents mixed evidence on the relation between tax avoidance and firm value. For example, some studies find a positive relation between tax avoidance and firm value and others find a negative relation. Based on previous studies, our study uses the annual cash effective tax rate (“CETR”) as a measure of tax avoidance. We contend that firms belonging to the low tax avoidance (CETR above the median) category, minimize their tax liability by using normal tax planning. We consider firms belonging to the high tax avoidance (CETR below the median) category to be engaging in excessive tax avoidance practices and hence are regarded as socially irresponsible. Thus, we posit that an impact investor would select firms that belong to the low tax avoidance category as these firms will pay their corporation tax responsibly and government may utilize a ‘fair share’ of the profit generated by firms to improve society.

Data and measures

We obtain our data from Datastream-Thomson Reuters and our sample consists of 607 companies listed on the London Stock Exchange (“LSE”) from 1999 to 2019. We rank firms based on ESG scores and then divide them into two groups. The top 50% of firms constitute the low ESG group and the next 50% of firms constitute the high ESG group. This exercise is repeated for TA which is measured using Cash effective tax rate (CETR). Using median CETR, we classify our sample of firms into two groups, that is, low tax avoidance and high tax avoidance. We make portfolio assignments that are based on ESG scores and TA for the sample firms. Portfolio return is measured using buy-and-hold abnormal returns (“BHAR”). In addition to using pure impact measures, we also rank firms using known market-based risk measures, including the size of the firm (“SIZE”), price-to-book ratio (“PTBV”), and leverage and market risk (“BETA”).

Findings

Overall, our findings reveal that an impact investment strategy that embraces social responsibility based on ESG scores and TA would yield impact investors a BHAR of 2.6% per annum and 14.3% in a three-year investment horizon. Conversely, an investment strategy based on portfolio of firms with low ESG and high TA may offer a much higher BHAR of 9.2% per annum and 36.8% for a three-year period, but these firms do not constitute responsible investments.

Our findings indicate that investors who combine impact with stock and market fundamentals will earn a higher BHAR (25.5%) by investing in a portfolio consisting of firms with high ESG and high PTBV. We can conclude that such portfolios not only offer socially responsible investments but also enables an impact investor to invest in firms with high growth potential.

We also indicate that socially responsible investors will earn a higher BHAR (33.1%) by investing in a portfolio consisting of firms with low TA and high PTBV. We can conclude that investors who invest in a portfolio with a socially responsible firms and firms with high growth opportunities will earn higher returns. On a relative performance analysis of the various investment strategies undertaken above, we find that a pure impact strategy of high ESG and low TA offers a BHAR of 14.3% in a three-year investment period. On the other hand, a mixed or combined investment strategy of impact plus firm and market fundamentals provides a return of 25.5% on portfolios of firms with high ESG and high PTBV and a BHAR of 33.1% on portfolios of firms with low TA and high PTBV. An impact investor who is committed to investing in only impact firms can earn a BHAR of 14.3% in a three-year investment period. This study also shows investors can choose a portfolio using low tax avoidance as an impact variable instead of ESG scores.

Conclusion

The primary goal of this paper is to explore and recommend an investment strategy based on impact criterion. Following previous literature, this study uses ESG ratings of firms as an investment criterion to choose impact firms. However, due to the lack of standardization in disclosure and reporting of ESG ratings by firms, it becomes necessary to explore an alternate measure. Given the close association between CSR and tax avoidance, we argue that tax avoidance can be used as an investment criterion for impact investing. Firms may argue that by reducing their tax expenses, their savings can be used for charitable purposes. However, this assertion becomes very challenging to prove, given the inconsistencies in the disclosure and reporting of charitable initiatives. 

To our knowledge, this is one of the first studies that integrates the empirical association of ESG ratings and tax avoidance into an impact investment strategy. We find that in a ‘pure’ impact investment strategy based on ESG and tax avoidance, investing in high‐ESG rated firms and low tax avoidance firms yields a buy and hold abnormal return of 2.6% per annum and 14.3% in a three-year investment horizon. Next, if impact investors were to combine traditional investment strategies based on risk with impact factors, we find that portfolios of high‐ESG and high price‐to‐book‐ratio firms earn 25.5% returns, while a portfolio of low tax avoidance and high price-to-book portfolios earn 33.1% in the long run. The contributions of our study are three-fold. First, to our knowledge, this is the first study that assesses an investment strategy performance based on impact using risk-adjusted returns across varying investment horizons. Second, this study introduces tax avoidance as an alternate impact measure. Finally, we provide an investment strategy that combines impact variables with firm and market fundamentals. 

The limitation of this study is that while we can assess the investment performance of an impact investment strategy, we are unable to measure the extent by which these impact investments generate a positive, measurable social and environmental impact. Future studies could explore this aspect of impact investing. This study also limits its focus to equities. Future work could encompass other asset classes such as fixed income or commodities. Until ESG reporting and disclosure is standardized globally, the search for the holy grail of alternate impact measures is imperative and critical, especially since impact investing is set to grow and gain momentum in the coming years.

Kumari Juddoo is a Finance and Accounting Senior Lecturer at the University of Westminster Business School

Issam Malki is a Finance and Accounting Senior Lecturer at the University of Westminster Business School

Sudha Mathew is the Assistant Head of School at Finance and Accounting at the University of Westminster Business School

Sheeja Sivaprasad is a Principal Lecturer in Finance at the University of Westminster  Business School

This post is adapted from their paper, “An Investment Strategy Based on Impact”, available on SSRN.