In an attempt to better identify socially responsible mutual funds and measure the effect of social responsibility on investment performance, the authors expand a common four-factor model by including two factors of social responsibility.

The authors expand the common four-factor model (market, small minus large, value minus growth, and momentum) to include top minus bottom (TMB) and accepted minus shunned (AMS) as two social responsibility factors. The TMB factor ranks companies by assigning a social responsibility score as determined by identifying strengths and concerns in the areas of employee relations, community relations, environmental protection, diversity, and product safety. The AMS factor is the difference between returns of companies permitted in socially responsible funds and those of companies engaged in activities that are typically shunned, such as tobacco, gambling, firearms, alcohol, the military, and nuclear power.

Consistent with prior literature, the authors find no statistically significant difference between the overall returns of socially responsible companies and the S&P 500 Index. However, the authors’ thorough analysis of how the TMB and AMS factors separately affect performance shows that high TMB increases alpha whereas high AMS decreases alpha. This finding means that mutual funds improve performance by holding companies that score high in the five social responsibility categories but offset this increase by shunning companies in certain industries, which decreases performance and results in an insignificant net effect.

This research gives some assurance to portfolio managers, investors, and advisers who work under environmental, social, and governance (ESG) investment constraints that although socially responsible investing may not enhance returns, neither does it penalize returns if investors choose these investment restrictions for other reasons. And there is the potential to earn positive alpha by focusing on the socially responsible investing categories and disregarding filtering by industry.

The MSCI ESG database rates companies on the basis of, among other factors, community relations (charitable giving, support for housing), diversity (promotion of women and minorities, family benefits), employee relations (strong union relations, profit sharing), the environment (pollution prevention, recycling), and products (product quality and safety). From the MSCI ESG database, the authors obtain data on 4,904 unique individual US common stocks over 1991–2011, which they filter down to 17,180 company-year observations with a strength or concern in at least two of the five social responsibility criteria. These ratings are used to determine the TMB score: The long side consists of a value-weighted portfolio of the top third (most socially responsible) of companies in at least two of the five criteria and not in the bottom third of any criterion, and the short side is a value-weighted portfolio in the bottom third (least socially responsible) in at least two of the five criteria and not in the top third of any criterion. The TMB score is matched to the subsequent 12-month stock returns, producing 196,316 company-month observations. The AMS score is the value-weighted returns of companies in accepted industries minus the value-weighted returns of companies in shunned industries.

For the returns of 5,786 US mutual funds over 1992–2012, the authors examine each fund’s alpha using the four-factor model and they examine the TMB and AMS betas using the six-factor model. Mutual funds are also graded on the weighted average social responsibility score of their holdings to confirm that social responsibility classiftion by the beta method corresponds closely to the funds’ contents.

The overlap of 250 securities contained in both the S&P 500 Index and the socially responsible MSCI KLD 400 Index is striking, and the authors note that this coincidence understates differences between the indexes. Although the small but significant alpha associated with high TMB scores makes a case for considering the social responsibility categories, it may be more practical to classify funds as socially responsible on the basis of a prospectus than to replicate the authors’ work. Further research could explore how each of the five social responsibility criteria separately affect alpha.