The performance of socially responsible funds: does the screeing process matter?

4 Résumé non technique . 5 Résumé court . 6 1. Introduction . 7 2. The impact of screening on SRI fund performance . 10 3. The SRI Market in France . 13 4. The Determinants of SRI Mutual Funds’ Financial Performance . 23 5. Conclusion . 31 References . 33 Appendix . 35 List of working papers released by CEPII . 47 CEPII, WP No 2011-12 The performance of socially responsable funds 3 THE PERFORMANCE OF SOCIALLY RESPONIBLE FUNDS: DOES THE SCREENING PROCESS MATTER? NON-TECHNICAL SUMMARY Socially Responsible Investment (SRI) is now quite popular in financial markets. This has prompted a surge of interest in the financial performance of mutual funds that practice SRI: Does the inclusion of environmental, social and governance criteria in the investment decision-making process hurt risk-adjusted returns, or does it lead to a “win-win” strategy, a sort of double dividend? As of 2010, more than fifty academic papers have examined this issue, all of which are very uniform in their methodology. They almost unanimously show that financial performance of SRI funds is not significantly different relative to their conventional peers or relative to a benchmark index. Actually, the absence of an overall effect is not surprising. SRI funds are very heterogeneous and sociallyor environmentally-friendly investments may be a source of competitive advantage in some situations, but not in all. The debate on the economic and financial impact of corporate social responsibility should move away from the question “does it pay to be good? ” to “when does it pay to be good? ”. In this study, we assess the financial performances within SRI mutual funds. In particular, we examine whether the financial performance of these funds is related to the characteristics of the extra-financial screening process. Our sample is composed with French SRI mutual funds. Modern SRI takes its roots in the US in the 1970s and spread slowly to other Anglo-Saxon countries and to the rest of the world. In Continental Europe, the growth of SRI dates back only to the 1990s. But now, the European market is larger and is expanding faster than the US one. This argument alone could be enough to justify interest in European markets. More importantly, the practices significantly differ on both sides of the Atlantic. In particular, almost all SRI funds in the US use exclusion criteria. This is far from being the case in Europe, particularly in France: in our sample, only one SRI fund out of three applied such criteria. Instead, in Europe, SRI funds select companies from all industries, provided that these companies are the leading ones with respect to ESG criteria (environment, social, and governance). This so-called best-in-class approach is often considered at the cutting-edge of SRI. In this study, we examine the significance of the extra-financial screening process applied by fund managers on their financial performance. To do so, we build three main sets of explanatory variables. First, we use the number of exclusion criteria to measure the extent of the screening intensity. We hypothesize a U-shaped relationship between screening intensity, measured by the number of exclusion criteria, and financial performance. The second variable of interest concerns the nature of the extra-financial screens, that is, whether fund managers focus on specific ESG issues and whether they apply sectoral or transversal screens. In particular, we hypothesize that the only damaging exclusion criteria for SRI investors are those which target specific sectors. Third, we examine the potential impact of the quality of the extra-financial screening process, which is measured in two different ways. On one hand, we use SRI ratings computed by Novethic (the leading information center in France on SRI) CEPII, WP No 2011-12 The performance of socially responsable funds 4 to gauge the social responsibility of the French SRI funds. On the other hand, we evaluate the “Strategy Distinctiveness Index” proposed by Sun, Wang and Zheng (2011), which captures managerial skill by assessing the extent to which a fund’s returns differ from those of its peers. Our study provides some salient results. First, as expected, we show that SRI mutual funds do not outperform the market, whatever the performance measure considered. Then, we confirm empirically that the SRI screening process may have a cost: the financial performance of SRI funds is hurt by the exclusion of non-socially responsible stocks. Like Barnett and Salomon (2006), we also find that this initial negative effect is partly offset as the number of screens increases. Further, we show that only sectoral screens (such as avoiding sin stocks) pull down financial performance, while transversal screens (commitment to UN Global Compact Principles, ILO/Rights at Work, etc.) do not have any impact. Moreover, it is not clear whether one of the ESG factors influences the financial performance of SRI funds more than the others, but these issues need further analysis. Lastly, when the quality of the SRI selection process is proxied by the rating provided by Novethic, its impact is not significant, while a higher strategy distinctiveness amongst SRI funds, which also gives information on the quality of the selection process, is associated with better financial performance.