Investor demand for mutual funds that are managed with the use of socially responsible investing (SRI) strategies continues to increase. Previous studies have examined the overall performance impact of those strategies over time. In this study, the authors examine whether SRI strategies add value by delivering superior performance to investors particularly during times of economic crisis.
The socially responsible investing (SRI) industry has continued to grow substantially despite the mounting evidence that investors largely pay a cost for ethics in the form of negative abnormal returns, or alpha. Possible explanations for the growth include belief-driven investor utility or a connection between firm ownership and social/religious expression. In this study, the authors examine US domestic equity funds and present findings in support of an alternative explanation: SRI—specifically the incorporation of environmental, social, and governance (ESG) factors into the investment decision-making process—serves to dampen downside risk during market crisis periods.
How Is This Research Useful to Practitioners?
The authors’ findings suggest that SRI strategies have more to offer investment clients beyond the hopeful promise of “doing good.” Consistent with previous research, they find no significant differences between the returns and alphas of SRI funds and peer conventional funds for the overall 2000–2011 study period. But relative performance is statistically different during crisis and noncrisis subperiods. During noncrisis subperiods, conventional funds outperform SRI funds in the range of an annualized 0.67%–0.95%, depending on which factor model is used. During the two crisis subperiods, however, SRI funds outperform conventional funds in the range of 1.61%–1.70% annually.
Of the 240 SRI funds analyzed, 209 of them use at least some form of product screening (for example, excluding alcohol, nuclear testing, or pornography). But outperformance during the crisis subperiods appears to be driven more by a focus on ESG issues and shareholder advocacy. Although funds that use product screens underperform conventional funds by 1.11% during noncrisis periods, they generate alphas that are not significantly different from those of conventional funds during crisis periods. In contrast, funds that use only ESG screens have alphas that exceed those of conventional funds by 2.18% during the crisis subperiods. Funds that are active in shareholder advocacy also significantly outperform conventional funds during the crisis subperiods.
The authors find that funds that use positive ESG screens (seeking out firms with superior ESG characteristics) have significantly positive alphas during the crisis subperiods, both in absolute terms and relative to conventional fund alphas. The same cannot be said about funds that use negative ESG screens (avoiding firms with inferior ESG characteristics).
The authors confirm that their findings hold even after they control for fund-level firm characteristics (e.g., book-to-market ratio, market capitalization, debt-to-equity ratio) and portfolio management characteristics (e.g., fund turnover, number of stocks, allocation to defensive industries).
How Did the Authors Conduct This Research?
The authors compile their list of 240 US domestic equity SRI mutual funds from 2000 to 2011 through extensive searches of various resources, including Morningstar, a previous study, and SRI websites. They also conduct a keyword search of the CRSP US mutual fund database’s name history.
They obtain survivorship bias–free fund-level data from CRSP and stock-level financial and trading information from CRSP and Compustat. They collect data on screening strategies (positive versus negative) and foci (products, ESG, shareholder advocacy, faith/religion) by looking through each fund’s prospectus in the US SEC’s Edgar database.
The authors compare the performance of SRI equity funds with a matched sample of non-SRI conventional equity funds. Consistent with previous SRI fund performance studies, they use the matching fund approach to select the conventional funds. During the overall 2000–2011 performance measurement period, the authors identify two crisis subperiods—March 2000 to October 2002 and October 2007 to March 2009—based on the peak and trough of the S&P 500 Index. The authors classify the remaining months as noncrisis subperiods.
They use the capital asset pricing model, the Fama and French three-factor model, and the Carhart four-factor model to calculate risk-adjusted alpha for the SRI and conventional funds during the overall 2000–2011 measurement period and for the crisis and noncrisis subperiods. The authors correct standard errors for autocorrelation using the Newey–West procedure and then calculate t-statistics to test significance.
The notion of SRI as an essentially defensive strategy is intuitively appealing. It is easy to see how the consequences of poor firm-level ESG decisions can remain hidden during good times and manifest during bad times. One of the authors’ more detailed findings is that when the ESG fund categories are examined separately, the governance-focused funds have the strongest crisis alpha, both in absolute terms and also relative to conventional funds. From an advocacy and ethics perspective, I found this finding intriguing.