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Home > Asset Management Best Practice > The Performance of Socially Responsible Mutual Funds

Asset Management Best Practice

The Performance of Socially Responsible Mutual Funds

by Luc Renneboog

Executive Summary

Socially responsible investment funds employ negative and positive screens to select firms for their portfolios. These screens are based on environmental, social, or ethical criteria.

Trade-off: SRI funds could perform better than conventional ones as SRI funds comprise more carefully and actively selected firms. However, SRI funds could perform worse as the screening reduces the diversification potential which comes at a cost.

SRI performance measurement should involve an asset pricing model that captures investment styles. The Fama–French–Carhart model includes the market, firm size, growth opportunities, and share price momentum. In addition, the performance of SRI funds should be compared with the performance of conventional (non-SRI) funds.

Recent research shows that the performance SRI funds around the world is below the expected performance (measured by, for instance, the Fama–French–Carhart model). Furthermore, SRI funds do not outperform their conventional counterparts.

Introduction

Over the past decade, socially responsible investment (SRI), frequently also called ethical investment or sustainable investment, has grown rapidly around the world. SRI is a process that integrates social, environmental, and ethical considerations into investment decision making. Unlike conventional types of investment, SRI funds apply a set of investment screens to select or exclude assets based on ecological, social, corporate governance, or ethical criteria, and SRI often engages in the local communities and in shareholder activism to further corporate strategies towards the above aims.

What Type of Investment Screens Do SRI Funds Employ?

Table 1 presents a summary of the SRI screens used by ethical funds around the world. Usually, SRI mutual funds apply a combination of the various types of screens. 64% of all socially screened mutual funds in the United States use more than five screens, while 18% of SRI funds use only one social screen (Renneboog, Ter Horst, and Zhang, 2008a). These screens can be broadly classified into two groups: negative screens and positive ones.

Table 1. SRI screens. (Source: Renneboog, Ter Horst, and Zhang, 2008b)

Screens Definitions Pos. or Neg. screen
Tobacco Avoid manufacturers of tobacco products.
Alcohol Avoid firms that produce/market alcoholic beverages.
Gambling Avoid casinos and suppliers of gambling equipment.
Defense/weapons Avoid firms producing weapons.
Nuclear power Avoid manufacturers of nuclear reactors and firms operating nuclear power plants.
Irresponsible foreign operations Avoid firms with investments in firms located in oppressive regimes such as Burma or China, or firms that mistreat the indigenous peoples of developing countries.
Pornography/Adult entertainment Avoid publishers of pornographic magazines; production studios that produce offensive video and audio tapes; companies that are major sponsors of graphic sex and violence on television.
Abortion/Birth control Avoid providers of abortion; manufacturers of abortion drugs and birth control products; insurance companies that pay for elective abortions.
Labor relations and workplace conditions Seek firms with strong union relationships, employee empowerment, and/or employee profit sharing. Avoid firms exploiting their workforce and sweatshops. +
Environment Seek firms with proactive involvement in recycling, waste reduction, and environmental cleanup. Avoid firms producing toxic products, and contributing to global warming . +
Corporate governance Seek companies demonstrating “best practices” related to board independence and elections, auditor independence, executive compensation, expensing of options, voting rights and/or other governance issues. Avoid firms with antitrust violations, consumer fraud, and marketing scandals. +
Business practice Seek companies committed to sustainability through investments in R&D, quality assurance, and product safety. +
Employment diversity Seek firms pursuing an active policy related to the employment of minorities, women, gays/lesbians, and/or disabled persons who ought to be represented amongst senior management. +
Human rights Seek firms promoting human rights standards. Avoid firms which are complicit in human rights violations. +
Animal testing Seek firms promoting the respectful treatment of animals. Avoid firms with animal testing and firms producing hunting/trapping equipment or using animals in end products. +
Renewable energy Seek firms producing power derived from renewable energy sources. +
Biotechnology Seek firms that support sustainable agriculture, biodiversity, local farmers, and industrial applications of biotechnology. Avoid firms involved in the promotion or development of genetic engineering for agricultural applications. +
Community involvement Seek firms with proactive investments in the local community by sponsoring charitable donations, employee volunteerism, and/or housing and educational programs. +
Shareholder activism The SRI funds that attempt to influence company actions through direct dialogue with management and/or voting at Annual General Meetings. +
Unmarried Avoid insurance companies that give coverage to unmarried couples.
Healthcare/ Pharmaceuticals Avoid healthcare industries (used by funds targeting the “Christian Scientist” religious group).
Interest-based financial institutions Avoid financial institutions that derive a significant portion of their income from interest earnings on loans or fixed-income securities (used by funds managed according to Islamic principles).
Pork producers Avoid companies that derive a significant portion of their income from the manufacturing or marketing of pork products (used by funds managed according to Islamic principles).

Negative Screens

The oldest and most basic SRI strategy is based on negative screening. These filters refer to the practice that specific stocks or industries are excluded from SRI portfolios based on social, environmental, and ethical criteria. A typical negative screen can be applied on an initial asset pool such as the S&P 500 stocks from which the alcohol, tobacco, gambling and defense industries, or companies with poor performance in labor relations or environmental protection, are excluded. Other negative screens may include irresponsible foreign operations, pornography, abortion, poor workplace conditions, violation of human rights, and animal testing. After performing a negative SRI screening, portfolios are created via a financial and quantitative selection. Some SRI funds only exclude companies from the investment universe when these firms’ revenues derived from “asocial or unethical” sectors exceed a specific threshold, whereas other SRI funds also apply negative screens to a company’s branches or suppliers. A small number of SRI funds use screens based on traditional ideological or religious convictions: for instance, they exclude investments in firms producing pork products, in financial institutions paying interest on savings, and in insurance companies insuring unmarried people.

Positive Screens

SRI portfolios are nowadays also based on positive screens, which in practice boils down to selecting shares that meet superior corporate social responsibility (CSR) standards. The most common positive screens focus on corporate governance, labor relations, the environment, sustainability of investments, and the stimulation of cultural diversity. Positive screens are also frequently used to select companies with a good record concerning renewable energy usage or community involvement. The use of positive screens is often combined with a “best in class” approach. Firms are ranked within each industry or market sector according to CSR criteria. Subsequently, only those firms in each industry which pass a minimum threshold are selected.

Combining Negative and Positive Screens

Negative and positive screens are often referred to as the first and second generation of SRI screens respectively. The third generation of screens refers to an integrated approach of selecting companies based on the economic, environmental, and social criteria comprised by both negative and positive screens. This approach is often called “sustainability” or “triple bottom line” (on account of its focus on people, planet and profit).

Shareholder Activism

The fourth generation of ethical funds combines the sustainable investing approach (third generation) with shareholder activism. In this case, portfolio managers or the companies specialized in granting ethical labels attempt to influence the company’s actions through direct dialogue with the management or by the use of voting rights at Annual General Meetings.

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Further reading

Books:

  • Schepers, Donald. Socially Responsible Investing. London: Routledge, 2009.
  • Vogel, David. The Market for Virtue: The Potential and Limits of Corporate Social Responsibility. Washington, DC: Brookings Institution Press, 2006.

Articles:

  • Renneboog, Luc, Jenke ter Horst, and Chendi Zhang. “The price of ethics and stakeholder governance: The performance of socially responsible mutual funds.” Journal of Corporate Finance 14:3 (June 2008a): 302–322. Online at: dx.doi.org/10.1016/j.jcorpfin.2008.03.009
  • Renneboog, Luc, Jenke ter Horst, and Chendi Zhang. “Socially responsible investments: Institutional aspects, performance, and investor behavior.” Journal of Banking and Finance 32:9 (September 2008b): 1723–1742. Online at: dx.doi.org/10.1016/j.jbankfin.2007.12.039

Report:

  • Renneboog, Luc, Jenke ter Horst, and Chendi Zhang. “Is ethical money financially smart?” Finance working paper 117/2006. European Corporate Governance Institute, February 2006. Online at: ssrn.com/abstract=887162

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