Mutual Funds Can Improve Performance by Investing in Responsible Firms

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Selecting mutual funds that screen irresponsible firms reduces portfolio diversity but can improve long-term financial performance.

Your firm's financial performance can be improved through socially responsible investing (SRI) - using mutual funds to invest in companies with strong CSR strategies that demonstrate responsible corporate citizenship.

A study by Michael Barnett of Rutgers Business School and Robert Salomon of NYU's Stern School of Business examines the relationship between SRI and financial results in mutual funds, measuring how social screening used by SRI funds affects financial performance.

Screening for Sustainability

Mutual funds that with SRI components often choose firms with good CSR - enforced environmental policies, a strong record of community involvement, and fair employee practices. However, if a fund's social performance criteria is too strict, it will exclude certain firms, leading to a less diversified portfolio and therefore greater risk on returns. Thus funds are also concerned with diversifying; fewer social responsibility screens mean stronger financial performance due to the ability to hedge greater risks with a more diverse portfolio. The funds that occupy the "middle ground" between these two extremes (e.g. using a medium social performance screen) yield relatively poor financial results.

The authors used modern portfolio and stakeholder theories to measure the link between financial and social performance in mutual funds practicing SRI. They conducted an empirical test on 61 SRI funds from 1972-2000. The US Social Investment Forum (a national non-profit organization that encourages and promotes the growth of socially responsible investing) gave information about the number and type of screening strategies of funds. CRSP data tracked each fund's financial performance and was supplemented with mutual fund information from Weisenberger and ICDI (both mutual fund tracking services that provide a standard directory of information on mutual funds and their holdings).

Three Important Findings Emerge

  • Financial returns decline but eventually rebound as the number of social screens increases. SRI funds using few screens improve financial performance by becoming more diversified. Funds that use many social screens (e.g. 7-12 screens in this study) may benefit by eliminating underperforming firms.

  • Community relations screening increases SRI funds' financial performance. Funds that include in their portfolio firms with good local community relationships perform better. They have fewer local restrictions, better access to skilled employees, and less criticism from activists, all of which reduce a firm's operating costs. Social responsibility screens based on labour relations and the environment, however, do not produce higher financial returns.

  • From 1992 to 2000, screened SRIs received an average 1.6 per cent premium on financial returns per year compared to the market.

This research explains how portfolio and stakeholder theories can be complementary. However, the majority of funds examined were less than five years old, so long-term financial outcomes cannot be known. A firm's up-front investments in environmental improvements, for example, may take years to pay off. Researchers should also note that the market's preference for social screens may change in upcoming years. Future research can examine the merits of different types of screening strategies in more depth.

Screen Big or Go Home

As a manager, you must either commit to broadly screening out socially irresponsible firms from your funds, keeping only top performers, or exclude very few firms to maintain your ability to diversify.

Be aware of changes in which social screens are being rewarded in the market, and pay attention to long-term trends since social initiatives may have extended payback periods.

Barnett, M., & Salomon, R. 2006. "Beyond Dichotomy: The Curvilinear Relationship Between Social Responsibility and Financial Performance." Strategic Management Journal.27.11: 1101-1122.


 

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