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Does environmental, social, and governance (ESG) investing add or subtract value from investment portfolios?
According to the findings of a trio of researchers, summarized in the new In Practice series, the answer is neither: Investors can both match index performance while also “doing good” for the environment and society.
What’s the investment issue?
Socially responsible mutual funds have grown rapidly over the past decade and now represent more than $8 trillion in assets under management (AUM) in the United States.
Despite the popularity of these funds, how much their specific financial screens contribute to fund performance is not always clear. The research article, “Do Social Responsibility Screens Matter When Assessing Mutual Fund Performance?” published in CFA Institute Financial Analysts Journal®, looks at the extent to which socially responsible (SR) techniques contribute to SR mutual fund performance and compares this source of performance to 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 a basket of conventional mutual funds or with a benchmark index. That is, prior studies have not attempted to break the performance down into components and separate out the SR effects.
Here, the authors decompose the returns of 284 SR equity funds into three components over the period October 2004 to August 2015. Those three components: market return, asset allocation returns that are above market return, and the effects of active portfolio management. They then add a fourth component that specifically measures the influence of SR screening.
The authors carry out two types of SR analysis. The first uses industry factors, and the second is based on such style factors as size and value. The authors believe the study constitutes the first attempt to create SR industry and style benchmarks. Typically, stocks with high SRI scores tend to be larger growth stocks concentrated in a handful of industries.
What are the findings?
Market movements explain more than three-quarters of the total return across the spectrum of the global SR funds analyzed, 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%, as opposed to around 17% for active portfolio management. In the United States, SR screening explains 4% of total performance variability. That means the contribution of SR screening to fund performance is 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 example, 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 analyzed 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 study results suggest that SR screening is a relatively minor component in the performance of SR funds. Investors can expect portfolio performance similar to that of conventional funds or of the benchmark while still meeting their SR objectives. As the authors put it, SR investors can “do equally well or badly while doing good,” which may help to allay the fear that SR investing comes at a performance cost. Quite simply, there is no performance cost.
The authors’ measurement of return sources allows 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 who believe that SR factors could lead to long-term outperformance may opt for more active SR funds.
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. The study did not look at the performance of SR screening under specific types of market conditions.
This article is an In Practice summary of “Do Social Responsibility Screens Matter When Assessing Mutual Fund Performance?” by Marie Brière, Jonathan Peillex, and Loredana Ureche-Rangau, from the CFA Institute Financial Analysts Journal®.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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