The ‘Price of Sin’ Aversion: Ivory Tower Illusion or Real Investable Alpha?
33 Pages Posted: 13 Sep 2015
Date Written: September 11, 2015
In their pioneering work, Hong & Kacperczyk [HK] (2009) document a significant outperformance of so- called sin stocks: publicly traded companies involved in producing alcohol, tobacco and gaming. Drawing on theories of neglected stocks and segmented markets, the authors suggest this outperformance to be due to a shunning effect caused by norm-constrained institutional investors who effectively pay a price for sin aversion. Motivated by a line of criticism against their research design, this study re-examines whether the sin stocks premium recorded by HK is actually investable for real world investors or derives from an ‘ivory tower style’ research design? We limit our analysis to only those stocks included in the global equity index benchmarks of institutional investors thereby excluding thousands of stocks usually considered too illiquid in practice. Among these stocks, we still document the sin stock premium in HK’s equal weighted sin-industry portfolios. Equal-weighted sub-industry portfolios are, however, practically barely investable for many institutional investors with their value-weighted benchmarks and are, if analysed in Fama-French models, exposed to a small cap bias in two ways. First, if small cap firms outperform large cap firms, then the equal-weighted portfolio is likely to outperform its value-weighted equivalent and a value-weighted market. Hence, we value-weight our sin-industry portfolios, which leads the premium for gambling firms to disappear. Second, Fama-French’s model controls for return differentials between small cap and large cap firms within all industrial sectors. The model is not designed to capture return differentials between small cap and large cap firms in a single sector such as consumer goods, which could drive the returns of sub-industries in this sector such as alcohol and tobacco. Hence, we add within sector control variables to our model which leads to a complete disappearance of any premium to sin stocks at the global level. When we conduct the same analysis in HK’s purely US universe, the sin stock premiums disappear even more convincingly. This implies that the sin stock premium and the price of sin aversion could be artefacts of an ivory tower research design and are not necessarily applicable to the real world.
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