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 provide short, easy-to-read summaries of recent and relevant academic research, to help you give your clients the best and most cutting-edge investment
advice.
Some months ago, I wrote an FA Mag column about a recent academic study that definitively showed that socially responsible investment (SRI) funds underperformed compared to their relevant benchmarks. I wasn’t surprised by the findings for two reasons. First, managers of SRI portfolios are picking stocks from a smaller universe of all stocks. Second, investing in firms because they are socially responsible is not consistent with fundamental investment decision-making. So, I then rhetorically asked: Why would anyone invest in an SRI portfolio? I conjectured the following reason: “Probably because it makes them feel good.” I then suggested that you should let your clients know that this good feeling they get when investing in an SRI portfolio is an important part of their return, especially if they become disappointed with the portfolio’s performance.
Well, believe it or not, in a new landmark study that will appear in the prestigious Journal of Finance, the authors pondered the exact same question that I had previously and rhetorically asked. The title of their paper is: “Why do investors hold socially responsible mutual funds?” The paper’s abstract contains a succinct summary of the answers and their findings:
“We find that both social preferences and social signaling explain socially responsible investment (SRI) decisions. Financial motives play less of a role. Socially responsible investors in our sample expect to earn lower returns on SRI funds than on conventional funds and pay higher management fees. This suggests that investors are willing to forgo financial performance in order to invest in accordance with their social preferences.”
So, I was kind of right. People invest in SRI portfolios because they want to ‘do what’s right’ and they also want others to know it. However, what surprised me was that this desire to invest with their social conscience was so strong that they were willing to (1) accept lower financial returns, and (2) pay extra fees for it. In other words, for some people, being socially responsible when it comes to investing is very important to them.
So, if you have clients who want to invest in an SRI portfolio, make sure that you explain to them that a big part of what they get in return is simply being able to invest with their conscience. They cannot expect financial gains that match similar non-SRI investments. That’s like having your cake and eating it too. This explanation will be especially important if their SRI portfolio eventually underperforms, as should be expected.
Kenneth A. Kim is chief financial strategist at EQIS.