On the Financial Performance of Socially Responsible Mutual Funds

1. On the Financial Performance of Socially Responsible Mutual Funds When “Goody-two-shoes” goes “Bad-to-the-bone”

2. SRI: The Goals • Provide competitive financial returns while fostering better social and environmental performance • SRI mutual funds are one SRI vehicle

3. Bloomberg’s definition

4. Strategies to achieve objectives • Selection or Screening: Investing in companies that meet certain social and/or environmental performance criteria, • Shareholder activism: using their rights as shareowners to encourage companies to be better corporate citizens, or • Community investment: allocating some of the fund’s assets for investment in disadvantaged urban and rural communities.

5. Socially Responsible Investing in the U.S. $2.16 trillion in 2003

7. Mutual Fund Screen Types($ Billions)

8. How are they Performing Financially? • The Good • The Bad • The Ugly

9. SRI the good #1: Popularity • A total of $2.16 trillion in assets were identified in professionally managed portfolios using one or more of the three core SRI strategies: Screening, Shareholder Advocacy and Community Investing • More than one out of every nine dollars under professional management in the United States today is involved in socially responsible investing. • Assets under management in screened portfolios rose 7% between 2001 and 2003. Meanwhile the broader universe of all professional managed portfolios fell 4% during the same time period.

10. Growth of SRI Investments ($ Billions) 1997-2003

11. General Electric Tyco Enron Arthur Andersen Qwest Xerox Worldcom Adelphia Why are they so popular? May be Corporate Breakdowns in the News

12. The Good #2: Reported Performance against broad indices

13. The Good #3: Papers from the mid-nineties • Luck (1993, 1998) finds half of the DSI’s outperformance is due to stock selection, which was, in turn, a function of the social screens • SRI mutual funds actually outperform a sample of matched conventional funds (Statman 2000; Guerard 1997; Kurtz 1997; Mallin, Saadouni and Briston 1995; Luther and Matatko 1994; Luther, Matatko and Corner 1992) • There is a “social factor”, which affects returns. If so, this would need to be estimated and utilized in risk management of socially screened portfolios.

14. The Bad #1: The Reality

15. The Bad #2: The Actual Performance Against Broad Indices

16. The Bad #3: Modern Portfolio Theory

17. The Bad #4: Recent Findings • Studies by Bauer, Kees, and Roger, 2002; Goldreyer and Diltz 1999; Plantinga and Scholtens 2001; and Sauer, 1997; and Geczym, Stambaugh and Levin, 2003. • SRMF tend to underperform • If SRMF beat a broad benchmark, it has to do with style investments rather that social investment • SRI constraint imposes large costs on investors. • Entine (2003) questions the validity of screening methodologies being used and the very legitimacy of the business of SRI.

18. The Bad # 5: The Rhetoric "The fact is that social investors as a demographic tend to be better-educated and more affluent than the general population." – Michael Jantzi (Research Associate) • “Over 70% of largest socially responsible mutual funds got top marks from Morningstar, Lipper in 2003” (Socialinvest.org) • “Analysis of expense ratios finds SRI funds neither more or less costly than unscreened funds of similar type” (Socialinvest.org) • Change of tone from 1995-2004: from “we beat broad benchmarks” to “you can potentially perform as well as a regular.”

19. The Ugly #1: Entrenchment • The SRI has been very aggressive towards its critics. • Timothy Middleton (CNBC): “I always attract critics who assert that SRMF are just as good as the other funds.” • Entine, Miami University • Geczy, Stambaugh and Levin (2003) have been demolished by SRI-Advisor.com- “unsound research design , sloppy work” • Stone, Siena College

20. The Ugly #2: The “4 Bs” are Killing Domini

21. So, How do they perform? • Girard, Rahman and Stone (2005): “Between and within financial performance” • Entine (2003) and Geczym, Stambaugh and Levin, 2003 report that SRI constraint imposes large costs on investors. • Orlitzky, Schmidt and Rynes (2003): “There is a positive association between corporate social performance and financial performance.” It would take “1,000 papers” to change the overall conclusions of their research.

22. Our methodology • We use monthly return in 117 Socially Responsible Mutual Funds from 1984 to 2003 to investigate: • Selectivity--the ability to select “better securities” (as compared to Lippers benchmark) • Diversification-- the cost associated with poor diversification (as compared to Lippers benchmark) • Net Selectivity-- the “true” cost associated with an investment product • Market timing-- the ability to accurately overweight (underweight) cash in the expectation of bearish (bullish) market. • Time and cross-sectional analysis of performance

23. The Model

24. Data • 20 years span: 1984-2003 • 117 SRI funds including 7 dead funds • Funds have at least 13 month of data • 18 Lippers Benchmark • Monthly estimate of Selectivity, Diversification, Net Selectivity and Market timing • Estimates are annualized

25. Findings: Net Selectivity

26. Selectivity and Net Selectivity Over Time (5-year span)

27. Market Timing (5-year span)

28. Determinants of Performance: Size and Age

29. Determinants of Performance: Ethical Screens and Activism

30. In sum • We find evidence of poor selectivity, net selectivity and market timing ability on the part of socially responsible mutual fund managers. • We also find that the size of the fund has nothing to do with its performance. • Older funds tend to have worse selectivity, as well as the highest cost for a lack of diversification. • SRMF with the most ethical screens have the least selectivity and net selectivity. • SRMF bear a significant cost for their lack of diversification, which cannot be legitimately related to the screening.

31. Conclusion • Is it possible to maintain economic returns while expressing a social concern about corporate conduct? • In accordance with modern portfolio theory, we find that a social responsible constraint entails a cost in the form of a lower reward-to-risk (diversification cost) and this cost can be viewed as a contribution to the cause. However, our paper also shows that SRMF entails costs associated with poor portfolio management skills, this cost is unnecessary and cannot be justified by any ideology.

32. On the Future of SRMF… • Our findings concur with Levine (2003) who contends that the SRI industry fails to incorporate reliable, objective standards for measuring a firm’s corporate social performance into commonly used ratings or other approaches of assessment. • Individuals that perform the social screening task for their customers do so using subjective, proprietary, and ‘secret’ methodologies. • Simply put, the proprietary ‘black box’ approach, with its inherent subjectivity and lack of transparency, brings into question the validity of screening methodologies being used and the very legitimacy of the business of SRI.

33. They have to make a choice • The SRI industry is in between 2 chairs: • Client wealth maximization • Social wealth maximization • They need to choose

34. Future Research? • Is there a Social Risk factor that explains the return generating process of individual stocks? • Unlikely…or it would have a negative loading • We definitely cannot measure it as the difference between social benchmark and non-social benchmark Returns

35. As Abraham Lincoln said… “It has been my experience that folks who have no vices have very few virtues”