The authors provide a holdings-based analysis of investment decisions made by US equity funds that incorporates fundamental factors, such as earnings growth, leverage, dividend yield, stock return, and volatility, along with socially responsible investment (SRI) considerations. They examine the extent to which investment decisions are driven primarily by traditional fundamentals rather than by environmental, social, and governance (ESG) performance.
What Is the Investment Issue?
The bulk of investment research addresses the potential performance differential between socially responsible investing (SRI) and conventional funds. Unknown, however, is the degree to which SRI funds make decisions based on financial data versus SRI considerations. It is difficult to analyze the stock-picking strategy from an external analyst perspective. Further muddying the waters is the fact that conventional funds integrate both SRI information and financial criteria into their investment decisions. The authors provide a detailed holdings-based analysis of SRI funds and compare them with matched conventional funds to provide insight into what factors drive the security selection processes of both approaches.
How Did the Authors Conduct This Research?
The authors examine the interplay between financial criteria and non-financial ethical dimensions in security selection for 47 US-domiciled active and passive funds that were identified by the Forum for Sustainable and Responsible Investment in 2014 as socially responsible. The authors analyze the number, nature (corporate governance, environmental, social), and type (restriction, exclusion) of screening criteria. There are subtleties between sectoral screens—such as avoiding “sin” stocks—and across screens (e.g., commitment to UN Global Compact principles or the International Labor Organization/Rights at Work). Positive screening criteria lead to higher weights of “best in class” environmental, social, and governance (ESG) companies.
Individual position weights can change because of movement in stock prices. So, the authors isolate those instances from those of managers changing the weight assigned to a firm in response to a change in ESG score.
The authors use data from Bloomberg from September 2009 through November 2015 to examine quarterly holdings and such fundamental data as EPS growth, price-to-book and sales ratios, dividend yields, and leverage. ESG ratings are provided by Sustainalytics and are mostly available beginning in year-end 2009. The authors look at relative ESG scores, which reflect the difference between a firm’s ESG score and the relevant sector’s average score, rather than considering only absolute ESG scores. They classify funds into two main categories—passive and active—and then by geographical scope and investment style. Investment style is differentiated by size, growth, and value.
What Are the Findings and Implications for Investors and Investment Professionals?
The authors find that SRI funds generally invest in profitable large-cap companies that make major investments. Absolute ESG scores for SRI funds tend to increase over time, and active US-focused funds have lower ESG scores than active international funds. Active US-focused funds may hold more companies, particularly small caps, which are characterized by lower ESG disclosure levels and thus have lower ESG scores.
The authors also find that firms with higher relative ESG scores are more heavily weighted in both passive and active SRI funds, but traditional fundamentals effectively guide the initiation and liquidation decision-making process for active funds. This is truer for active growth funds than for active value funds, which may buy into deteriorating fundamentals. Passive SRI funds follow their indexes and tend to liquidate stocks if their ESG score deteriorates or if volatility increases.
The research supports the findings of previous researchers that conventional indexes and Fama–French–Carhart factors are more useful in explaining SRI fund returns than social responsibility indexes or factors. Another key takeaway is that conventional growth funds follow certain valuation criteria more precisely than their SRI counterparts. Similarly, conventional value funds show a more pronounced value tilt than matched ethical funds.
Abstractor’s Viewpoint
Recent regulation, such as the Green Growth Act in France and Dodd–Frank Act in the United States, ensures that developed markets have some level of sustainability and governance. In fact, the MSCI Emerging Markets (EM) ESG Leaders Index has outperformed the regular MSCI EM Index in the last one, three, and five years, with five-year outperformance of 2.4% per year.