This In Practice piece gives a practitioner’s perspective on the article “Do Social Responsibility Screens Matter When Assessing Mutual Fund Performance?” by Marie Brière, Jonathan Peillex, and Loredana Ureche-Rangau, published in the Third Quarter 2017 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Socially responsible mutual funds have grown rapidly over the past decade and now represent more than US$8 trillion in assets under management in the United States.
Despite the popularity of these funds, it is not always clear whether and by how much their extra-financial screens contribute to fund performance. This study looks at the extent to which socially responsible (SR) techniques contribute to SR mutual fund performance and compares this source of performance with more traditional sources, such as market movements, asset allocation, and active management.
How Do the Authors Tackle the Issue?
The authors create a methodology—based on well-known SR indexes worldwide—to disentangle SR screening from other sources of return. This approach differs from previous studies on SR fund performance, which have compared the performance of a basket of SR funds with that of a basket of conventional mutual funds or with that of a benchmark index. That is, they have not attempted to break the performance down into components and separate out the SR effects.
In this study, the authors decompose the returns of 284 SR equity funds over the period October 2004–August 2015 into three components: market return, asset allocation returns that are above market return, and the performance of active portfolio management. They then add a fourth component that specifically measures the effect of SR screening.
The authors carry out two types of SR analysis. The first analysis uses industry factors, and the second is based on such style factors as size and value. They believe this study represents the first attempt to create SR industry and style benchmarks. They chose these factors in the belief that industry type and size are important factors in SR investing, given that stocks with high SRI scores tend to be larger growth stocks concentrated in a handful of industries.What Are the Findings?
Across the global SR funds analysed, market movements explain more than three-quarters of the total return, substantially outranking all the other sources of performance. The combined contributions of the three other sources of return—SR screening, asset allocation, and active management—account for about a third of returns.
The contribution of SR screening alone is considerably less than the contribution of active management, for both the industry factors and the style factors. Indeed, the contribution of SR screening to the performance of global SR funds is only about 10%, versus about 17% for active portfolio management. For the United States, SR screening explains 4% of total performance variability. In other words, the contribution of SR screening to fund performance is actually quite modest.
These findings are based on an average of all the funds in the sample and hide considerable differences between individual SR funds and groups of funds. In a quarter of the funds, for instance, the effect of SR screening on returns is less than 1%. It is possible, therefore, that these funds may have been misclassified as belonging to the SR family. At the same time, several of the funds analysed appear to take a highly active SR approach, with SR factors making up more than 14% of their performance.What Are the Implications for Investors and Investment Professionals?
The findings suggest that SR screening is a relatively minor component in the performance of SR funds. Investors in SR funds can expect portfolio performance similar to that of conventional funds or of the benchmark while meeting their SR objectives. As the authors put it, SR investors can “do equally well or badly while doing good”—which may allay the fear of some investors that SR investing comes at a performance cost. Quite simply, there is no performance cost.
The measurement of return sources that the authors devise could allow investors to explicitly choose SR funds in which SR screening has either a large or a small effect on performance, depending on the individual investor’s aims. Those investors wishing to emphasize social responsibility in their portfolios may choose funds in which SR factors make little difference to returns, whereas those believing that SR factors could lead to long-term outperformance may opt for more active SR funds.
The finding that average performance hides considerable time-series and cross-sectional differences in the returns of SR funds suggests that socially responsible investors could improve portfolio performance by selecting managers who have timing skills and deep knowledge across industry sectors. For example, SR screening may outperform in certain market situations, such as financial crises, but underperform in other types of markets. This study did not look at the performance of SR screening under specific types of market conditions.