I’m an active academic and long-time finance professor, so I stay on top of the latest academic research in the fields of finance, especially investments. On occasion, I will provide short, easy-to-read summaries of recent and relevant research results, to help you give your clients the best and most cutting-edge investment advice.
Advisors, do you have clients who want to invest in Corporate Socially Responsible (CSR) or Socially Responsible Investment (SRI) funds? They may insist on it, so that they can invest in a way that is consistent with their ethics and social conscience. Normally, when we make investment decisions, we use the usual investment and financial criteria and analyses, such as looking at the stock’s beta, the firm’s valuation ratios, the firm’s profitability, and etc. You know as well as I do that when investors use non-investment criteria (such as whether or not they are familiar with the firm or work at the firm, etc.) then their investments may not generate good or fair risk-adjusted returns. Investing in firms simply because they are socially responsible is like the doing the latter. As such, when people invest in CSR or SRI funds, then they should expect some underperformance relative to the funds’ relevant benchmarks.
However, there are still some people who believe that investing in CSR or SRI funds is consistent with maximising risk-adjusted returns. They usually make the following two arguments. First, socially responsible firms have better reputations, so they should be able to enjoy low financing costs that can lead to high returns. Second, socially responsible firms are sued less often and pay less in fines, so they should be able to keep more of their profits. Eh, I have to admit, these are pretty good arguments. So, I will let the academic evidence decide who is right.
In a new paper that will appear in the April 2017 issue of the Journal of Banking and Finance, a top scholarly journal, the authors study over 2,000 funds. They argue that prior studies on SRI or CSR funds are flawed because those studies simply categorized funds as being either socially-responsible or conventional. This categorization leads to too many other differences between funds, and it ignores the fact that firms can have varying degrees of social responsibility. So, in the new study, they compare low-CSR funds to high-CSR funds. They find that high-CSR funds underperform relative to low-CSR funds. Their evidence is both compelling and robust. So, I feel we have finally hammered the nail in the coffin, so to speak. That is, when investing in SRI or CSR funds, one should expect some underperformance.
So, why should anyone still invest in a CSR or SRI fund? Probably because it makes them feel good. They are investing in a way that is consistent with their ethics and conscience. In fact, in the new study, they find that CSR investors do not chase returns like non-CSR investors do. This suggests that CSR investors are not just focusing on returns when they invest. In economics, whenever we say someone is getting any kind of benefit, we call that benefit “utility.” For investors in CSR or SRI funds, they are potentially getting their utility from two sources: (1) from the good feeling that they get from investing in a socially responsible way, and (2) from any financial returns on their funds. Other investors may only be getting their utility from one source: from the financial returns. So, if a CSR or SRI fund underperforms, the investor might be okay with it. That person is still enjoying utility from investing in a socially responsible way. If you have clients who want to invest in CSR or SRI funds, then make sure you educate them about these tradeoffs they face.
Kenneth A. Kim is chief financial strategist at EQIS.