sou · GWB3107 · 2008-11-28 00:00:00 — Imposing SRI constraints reduces the diversification benefits to less favourable risk-return tradeoffs. The difference between the certainty equivalent returns on a portfolio with and without SRI constraints clearly reveals the costs of trying to do well via investments. It appears that investors who have a strong belief in the traditional CAPM and a disbelief in managerial ability bear very cost in terms of certainty equivalent loss. However, as soon as the investor beliefs shift in the direction of multifactor models such as the FFC model, then the costs of imposing SRI constraints rises significantly to about 30 basis points per month. A recent study by Renneboog, Ter , and (2008a) compares socially responsible and conventional equity funds in 17 countries. They determine FFC 4-factor alphas (annualized) for equally weighted portfolios of SRI funds and conventional funds. The returns of the benchmark portfolios are in local currency and are evaluated from a local investors perspective, i.e., with local benchmark factors and local risk-free rates. Figure 1 shows the 4- factor alphas for the SRI funds as well as their conventional counterparts. SOU 2008:107 Bilaga 5 Figure 1 SRI and Conventional risk-adjusted performance around the world Risk-adjusted Performance (%) at annual basis Source: Renneboog, Ter ,and (2008a). It appears that in all 17 countries under consideration, the SRI mutual funds underperform their benchmark. For seven countries (, , , , the UK, , and ), the authors find a significantly negative risk-adjusted performance. However, they report a significantly negative difference in performance between SRI funds and conventional funds only for and . This result implies that although SRI funds economically underperform conventional funds in all countries, the underperformance is only statistically significant for two out of the 17 countries. The empirical evidence on the nonsignificant difference between SRI and conventional responsible funds focuses mainly on equity funds. In a recent study, Derwall and Koedijk (2008) evaluate the performance of SRI bond funds and the SRI funds that hold both debt and equity (balanced funds). the period 1987 2003, these authors find that socially responsible fixed-income funds show a risk-adjusted performance similar to that of their conven- SRI balanced funds even outperform conven- tional balanced funds by about per year. Derwall and Koedijk's results are robust for various performance evaluation techniques and imply that SRI constraints do not negatively affect fixed-income fund performance. To summarize, most empirical studies provide evidence that the risk-adjusted performance difference between SRI funds and their conventional counterparts is not statistically different from zero. In the U.S. and UK, the average performance of SRI funds and conventional funds is comparable. and are the only two countries for which researchers find a significant under- performance. Nevertheless, socially responsible investing has expe- rienced a strong growth. 3 The Appeal of Socially Responsible Investing An important observation in the recent SRI literature is that socially responsible investors care about other issues than performance only. Note that this does not imply that performance of pension or mutual funds is not relevant. Like conventional investors, socially responsible investors also have to save/invest for their own personal financial planning such as retirement. Socially responsible investors care about the integration of personal and societal values in the traditional investment decision process. In a sequence of papers, Statman (2007a, 2007b, 2007c) portraits socially responsible investors. Who are those people and what drives them? Bollen (2007) and Renneboog, Ter and (2006) relate this part of the SRI literature with a more quantitative approach to disentangle the difference in behavior between conventional investors and socially responsible investors. In the previous section we have seen that a lot of research regarding socially responsible investing focuses on the question whether there is a performance difference between SRI funds and their conventional counterparts. However, many investors may derive utility from owning companies or mutual funds that care about their personal expressive characteristics as well. Bollen (2007) introduces a multi-attribute utility function that incor- porates personal or societal values into the traditional investment decision problem. Even in the case that social responsible screening negatively affects fund performance, investors can nevertheless derive nonfinancial utility by investing in SRI funds consistent with their environmental, social, and ideological issues. To examine whether SRI investors care more about these nonfinancial issues than about fund performance, Renneboog, Ter , and (2006) extend the framework of Bollen (2007) and examine the flow-performance relation of SRI and conventional funds. For conventional mutual funds and hedge funds, researchers know well that financial attributes, such as risk-adjusted and raw past returns, significantly affect the money flows into the funds (see, e.g., and Tufano, 1998; and Agarwal, , and Naik, 2004). Top- performing funds attract most of the inflow, while poor perform- ing funds are affected by outflows. Renneboog, Ter , and (2006) report that SRI investors around the world care less about past performance than do conventional fund investors. In comparison to conventional funds, the authors find a somewhat weaker reaction to positive performance in the previous year, but more interestingly, that the flows of SRI funds are significantly less sensitive to past negative returns. Furthermore, they report that the types and the intensity of the screening significantly affect the money flows. SRI funds that are characterised by primarily negative screens, or by mainly sin and ethical screens, receive larger money inflows and have a weaker sensitivity to negative returns. The reduced sensitivity to past negative returns corresponds to Bollens (2007) study on U.S. However, Bollen (2007) reports a stronger flow sensitivity to past positive returns. According to Renneboog, Ter , and (2006) this result can be explained by the fact that U.S. SRI funds mostly use ethical and sin screens. Finally, Renneboog, Ter , and (2006) report that stock-picking based on in- house SRI research increases the money flows by about per month. This result indicates that investors in SRI funds care more about nonfinancial attributes and pay less attention to financial performance. The findings of Bollen (2007) and Renneboog, Ter and (2006) correspond with the way Statman portraits socially responsible investors. A clear picture of a social responsible investor does not exist. Social responsibility has different inter- pretations for different investors as well as their aims. Some investors care about the environment, and prefer a portfolio where polluting companies are excluded, while alcohol, gambling and tobacco companies are not considered as social responsibility But what socially responsible investors share is consistency between their values and investments. They care about perfor- mance, but some of them are even willing to sacrifice returns in order to have peace of mind. 4 Are SRI Factors Priced by the Market? One of the most controversial issues in the SRI literature is whether the introduction of nonfinancial criteria in the investment decision process affects financial performance. But beforehand, it is difficult to claim that criteria such as environmental, social, and corporate governance targets will positively or negatively affect performance. At the heart of the discussion is the question of whether these nonfinancial targets are priced by the market. In the recent SRI literature we can distinguish three alternative hypotheses. The neglect or doing good but not well hypothesis states that the expected returns of social responsible stocks are lower than are those of the stocks of conventional, or even controversial, companies. Alternatively, the errors in expectations or doing well while doing good hypothesis states that expected returns from social responsible firms are higher than are those of conventional firms. Finally, in the no effect or irrelevance hypothesis, the social responsibility feature is not priced in the market, and expected returns of SRI companies will be equal to those of conventional companies. Jaworski (2007) conducted a survey among research analysts and investors to examine how and the ways in which they incorporate ESG issues into their analysis. Jaworski's results show a growing interest in SRI. Table 1 shows which ESG factors matter the most for the investment community. It appears that corporate governance indicators are the most important factors, and that environmental responsibility and community involvement receives relative less attention. Furthermore, most participants think that ESG factors have an impact on market value and financial performance, in particular over the long term, and that the information on ESG issues is not fully reflected in the stock prices. Table 1 Relative Importance of ESG issues to investors investment decisions and recommendations Source: Jaworski (2007), , and (2008) examine whether environmental information is actually used by financial analysts in their equity valuation reports on two industries: the chemical and the oil and gas industry. Although companies increasingly report environmental information, the authors find that only of the financial analysts equity valuation reports actually contain envi- ronmental information. Surprisingly, environmental information is used more often by American analysts than by European, and it is used more often for North American than for European compa- nies. Apparently, the higher litigation risk faced by American companies makes analysts focus more on environmental factors when valuing American companies. From a theoretical point of view, we could argue that incor- porating ESG targets reduces potential costs of conflicts between society and corporations, and therefore may lead to a higher shareholder value. However, according to traditional finance think- ing, the focus in companies should be only on shareholder value maximization. As soon as the interest of other stakeholders, such as, for example, employees or the environment in general, is taken into account, the economic efficiency and managerial incentives can be negatively affected. Thus, the implementation of the so- called stakeholder theory could be a prescription for destroying firm value and reducing social welfare (, 2001). As stated by Tirole (2001) management can almost always rationalize any action by invoking its impact on the welfare of some stakeholder. Although some well-known economists express a negative view on incorporating nonfinancial goals in the investment decision process, corporate social responsibility is becoming increasingly popular. Part of this popularity can be explained by pressure from society in general. Media attention or the growing social and environmental awareness of people may lead to a boycott of those firms that do not take these issues into account in their business policy. Thus, the effects of social norms on markets is one of the key interests in recent SRI literature. The fact that a growing group of investors, among which are institutional investors such as pension funds, ignore a set of stocks could negatively affect the stock prices of those companies. The limited risk-sharing opportunities and the increased litigation risk of the products of those companies has the potential to increase the expected returns of the companies involved. and Kacperczyk (2008) test the so-called 'neglect' hypothesis for a sample of sin stocks over the period 1965 2006. These authors define a sin stock as a publicly traded company involved in the production of alcohol, tobacco, or gaming. In the U.S. SRI industry, sin screening is the most popular screening structure, i.e., of the SRI mutual funds use some kind of sin screen, which implies that such funds exclude companies involved in the manufacturing of tobacco products, alcoholic beverages, and casinos and suppliers of gambling equipment from the investment opportunity set. and Kacperczyk (2008) find that sin stocks outperform comparable stocks by about at an annual basis. An explanation for their result is that the sin stocks have less institutional ownership due to social norms pressure compared with the otherwise comparable stocks. Moreover, the sin stocks have less analyst coverage. Although hedge funds, mutual funds, and individual investors will also feel the social pressure, it can nevertheless be expected that some of them buy these often neglected and cheaply priced sin stocks. The alternative hypothesis that receives a lot of attention in the empirical literature is whether stocks of social responsible companies have higher expected returns than do those of conventional stocks. This doing well while doing good or errors in expectations hypothesis can only hold true when stock markets misprice information on ESG in the short run. Selecting firms with above-average scores on these ESG targets can then lead to a better financial performance in the long run. Derwall, Gunster, , and Koedijk (2005a) use monthly eco- efficiency ratings obtained from Innovest Strategic Value Advisors, and find a positive relation between the rating and firm value as measured by Tobins q. Eco-efficiency is defined as the creation of more value with fewer environmental resources, resulting in less environmental impact. For the period 1995-2003, an investment strategy based on the eco-efficiency scores shows that a portfolio that contains stocks with the highest scores outperforms a portfolio that contains stocks with the lowest scores by almost per annum (Derwall, Gunster, , and Koedijk (2005b). This result supports the claim that the stock market undervalues the publicly available environmental information, which is at odds with market efficiency. Alternatively, the eco-efficiency premium may also reflect a premium for missing risk factors in asset pricing models. Previous research on the relation between environmental and financial performance has been extended by Semenova and (2008). While Derwall et al. (2005a) only use eco-efficiency as an environmental measure, Semenova and (2008) extend the analysis to a multi-variate three factor environmental model. The environmental measures are obtained from . GES assigns stocks an environmental risk rating that includes the industry risk level and company specific risk level. The authors make a distinction between inherent environmental industry risk, preparedness and performance. Environmental preparedness reflects reputational benefits from a companys environmental policy, management systems and regular reporting. This distinction allows the authors to distinguish between industry effects and company specific environmental effects. The authors find a positive relation between environmental preparedness and firm value, while preparedness has a negative impact on operating performance. For low risk industries, environmental preparedness and performance have a positive impact on market value, but no effect on operating performance. Apparently, as stated by the authors, companies attempting to be environmentally responsible, show low profitability but a high market value. (2007) uses the GES environmental risk ratings in an investment strategy setting. Using the FFC model, the author finds that a more responsible low environmental risk portfolio has a similar risk-adjusted performance as a high risk portfolio over the period 2004-2006. This indicates that responsible investing does not necessarily lead to poor performance. Using event study methodology, and (2008) examine whether environmental incidents affect firm value. The authors observe 142 environmental incidents during the period 2003-2006. The incidents appear to have a negative significant effect for European firms, while the effect is nonsignificant for U.S. Apparently, U.S. firms are less sensitive for environ- mental incidents than European firms. Corporate scandals such as in the , and and in the U.S., have led to increased attention on corporate governance. Corporate governance is usually defined as the relationship between all the stakeholders in a company. This relationship includes the shareholders, directors, and the manage- ment of a company, as defined by the corporate charter, by laws, formal policy, and the rule of law. Such designs induce or force management to internalize the welfare of stakeholders (Tirole, 2001). Gompers, Ishii, and Metrick (2003) analyze the relation between corporate governance and long-term equity returns for the U.S. They report that an investment strategy based on selecting well-governed companies outperforms a strategy based on selecting poorly governed companies by about per year. Combined with a positive relation between good corporate gover- nance and firm value, this result clearly indicates that good corpo- rate governance increases financial performance for U.S. compa- nies, and that the information is not incorporated in the stock price. , Gunster, and (2004) examine the impact of corporate governance on firm value by using a sample of European corporate governance ratings of Deminor. They find that on average, there is a positive relation between corporate governance rating and firm value. However, the relation appears to be much stronger for EMU countries than for the UK. Moreover, an investment strategy that is long in a good corporate governance portfolio and short in a poor corporate governance portfolio leads to an average annual return of for EMU countries, while it is more than for the UK. This result implies that in EMU countries, the corporate governance standards are already incorpo- rated in stock prices, but in the UK, the adjustment is still taking place. In traditional finance, employees were considered as a cost that had to be minimized. Moreover, opponents of the stakeholder theory claimed that taking into account the interests of other stakeholders, such as employees, destroys value. Nowadays, management philosophies are more likely to recognize employees as important organizational assets (see, Zingales, 2000). Edmans (2008) examines whether employee satisfaction is related to equity prices. It appears that a portfolio of firms from the 100 to Work For in generates a risk-adjusted return of about on an annual basis over the period 1984 2005. (Since 1998, has published this list of companies in its magazine; before 1998 it was only published in book form.) The positive relation between employee satisfaction and shareholder return indicates that the stock market does not incorporate this publicly available information in the stock price, at least not in the short run. Apparently, environmental, social, and corporate governance factors are not always priced in the market. Now the question is, can social responsible investors do both well and good? The studies by Edmans (2008), Gompers, Ishii, and Metrick (2003), and Derwall, Gunster, , and Koedijk (2005b) show that selecting firms with above-average scores on environ- mental, social, or corporate governance targets can lead to a better financial performance. These studies strongly support the doing well while doing good or errors in expectations hypotheses. In contrast, and Kacperczyk (2008) show evidence for the doing good but not well or neglect hypotheses. In their study, sin stocks outperform comparable stocks by about annually. However, a recent study by Statman and Glushkov (2008) arrives at the opposite conclusions. Statman and Glushkov show that the return advantage of selecting stocks of U.S. companies with high social responsibility scores is almost canceled out by the return disadvantage of neglecting stocks of so called shunned U.S. Shunned stocks include sin stocks as well as stocks of companies involved in firearms, military and nuclear industries. Nevertheless, over the period 1992 2007, a portfolio strategy with a tilt towards stocks of companies with high social responsibility scores outperformed a conventional portfolio. Although econo- mically significant, the outperformance is statistically significant only in case of the Fama-French factor model. Nevertheless, by following a best-in-class approach in the construction of port- folios, socially responsible investors can do both well and good. 5Optimal SRI Strategies: the Divestment versus the Engagement Strategy Another extensively studied question concerns optimal SRI strate- gies for portfolio management: should a SRI strategy lead to a divestment policy or an engagement strategy? In a recent study, Renneboog, Ter , and (2008b) describe the development of the SRI industry across the world. Although the first signs of ethical investing can be found in the bible, the (1928) was the first modern mutual fund to screen its investment portfolio based on religious traditions. Sinful companies, such as the companies involved in the production of alcohol, were excluded from the investment portfolio. In 1971, the was the first fund to use screens that were not based on religious traditions. However, it did avoid investments in the weapon industry. Although the first generation of SRI funds primarily used negative screening structures, the second generation mainly applies positive screening structures. This structure implies that SRI funds select companies for their investment portfolios when such companies meet superior environmental, social, or corporate governance standards. Often, SRI funds follow a best-in-class approach, selecting firms within an industry when the firms pass a minimum threshold. The third generation of SRI funds combines the negative and positive screens into what is referred to as "sustainable investing." The fourth and newest, most modern generation of funds combines sustainable investing with share- holder activism. The fourth-generation portfolio managers try to be actively involved in the companys policy through direct dialogue or via the annual meetings with the shareholders. For a more extensive overview of the historic development of the SRI industry, we refer to Sparkes (2002). In SRI we can distinguish three main investor strategies. First of all, SRI investors can screen their investment portfolios or mutual funds on social, ethical, environmental, or sin criteria. Second, socially aware investors may exhibit shareholder advocacy. Finally, SRI investors may be involved in community investing, in which capital is directly provided to communities underserved by traditional financial services. SIF (2005) reports that in the U.S., of the total assets under management (AUM) in the SRI industry is socially screened only, and of the total AUM exhibits shareholder advocacy only, while of the total AUM is involved in community investing. Renneboog, Ter , and (2008a) develop a list of SRI screens used by SRI funds around the world. They identify 21 different screening criteria, which are classified into four main categories: sin, ethical, governance and social, and environmental. Table 2 summarizes the most interesting characteristics of SRI funds around the world. Table 2 Summary statistics of SRI funds around the world Percentage of funds with Governance & Social screens Source: Renneboog, Ter , and (2008b). It appears that of the U.S. SRI funds apply negative screening, while in of the funds apply one or more positive screens. Sin screens are the most popular in the U.S., but in , we more often find governance, social, and environmental screens. In the UK, all screens are more or less equally popular.