The Effect of Socially Responsible Investing on Mutual Fund Performance and Fees

This paper extends previous research on socially responsible investment (SRI) mutual funds in several directions. First, we study separately the distinct contributions of before-fee performance and fees to mutual fund net performance. Second, we investigate the pricing of SRI funds. Third, we analyze the role of management companies in the determination of SRI funds’ performance and fees. Finally, we improve on existing methods by applying the matching estimator methodology and making full use of the panel structure of the dataset. We show that in a sample of U.S. equity funds in the period 1997-2005, SRI funds had higher fees and better beforeand after-fee performance than comparable conventional funds. Differences, however, were driven exclusively by SRI funds run by management companies that specialize in SRI. ∗Department of Business Administration, Universidad Carlos III de Madrid. The authors would like to thank Manuel F. Bagues and seminar participants at Universidad Carlos III for very helpful comments. The usual disclaimer applies. The financial support of the Spanish Ministry of Education and Science (SEJ200506655/ECON and SEJ2007-67448) and of the BBVA foundation is gratefully acknowledged. Corresponding author: Javier Gil-Bazo, Universidad Carlos III de Madrid, Department of Business Administration. Calle Madrid, 126. 28903 Getafe, Madrid Spain. E-mail: javier.gil. bazo@uc3m.es. Previous research on socially responsible (SRI) mutual funds has focused on determining whether SRI funds have lower financial performance than conventional funds. In this paper, we bring clarity to the debate on SRI funds’ performance by identifying and separately addressing questions that have been confounded in previous research and by using a methodology that overcomes some of the limitations of previous studies. First, we make a clear distinction between the two components of mutual fund net financial performance: before-fee performance and fees. This distinction is essential to address what may be the main question in the study of socially responsible investment, namely whether socially responsible investment reduces mutual funds’ ability to generate risk-adjusted returns. Standard portfolio choice theory implies that imposing constraints on the investment opportunity set cannot improve performance. Since one of the defining characteristics of most SRI funds is that they exclude companies from sectors such as tobacco, alcohol, or gambling from their investment universe, it follows that their before-fee risk-adjusted performance should be no higher than the one they could obtain if they lifted those exclusionary restrictions. Investigating before-fee performance enables us to evaluate directly whether social responsibility restrictions reduce the maximum performance attainable by mutual funds, without the potentially confounding effect of fees. Second, by explicitly investigating fees, we are able to address questions that have received little attention in prior studies. While the implicit assumption in most previous work is that differences in performance between SRI and conventional funds would be due to differences in SRI funds’ ability to generate risk-adjusted returns, differences in reported performance (which is net of fund expenses) could as well be due to differences in the fees charged by SRI and conventional funds. In other words, investors in SRI funds could be paying an explicit price for the ethical value of their investments in the form of higher fees. Further, focusing on fund fees allows us to shed light on the way in which fund fees are de-