Socially Responsible Funds and Market Crises. John Nofsinger, University of Alaska Anchorage Abhishek Varma, Illinois State University

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1 Socially Responsible Funds and Market Crises John Nofsinger, University of Alaska Anchorage Abhishek Varma, Illinois State University

2 Socially Responsible Investing (SRI) The performance of SRI strategies indicates that investors seem to pay a cost for going good (Renneboog, et al., 2008) Yet, SRI investment strategies have outpaced the growth in overall professionally managed assets (USSIF, 2010) Assets in SRI strategies grew by 380% since 1995 to $3.07 trillion in Universe of assets grew by 260% since 1995 to $25.2 trillion in Why are SRI strategies growing? Nature of ESG and SRI dampens downside risk. Investors may be willing to give up some upside performance to limit downside returns (Prospect Theory).

3 Prospect Theory Value Function Investors tend to frame investment choices in terms of potential gains and losses relative to a specific reference point according the S- shaped value function: Investor Appreciation and Pain in Gains and Losses Utility -$1,000 Y X Losses $1,000 2,000 Gains Z

4 SRI and Downside Risk SR firms are less likely to suffer large, negative events in ESG areas during both bull and bear market periods. Suffer less from legal prosecutions and fines, enjoy stable relations with governments, including regulators (McGuire, et al., 1988) There is a greater visibility of the negative corporate behaviors during the poor economic times than in the good times. Hirschliefer s (2008) legal attraction theory, Shefrin and Statman s (1993) liberalism/paternalism pendulum. The lower downside risk of SRI strategies, particularly relevant during crises periods, could attract investors.

5 Data Sample of 239 US Equity SRI funds during the period Fund list: Morningstar, SRI Studies, SRI websites and name history keyword search of CRSP MF Database. Fund investment objectives and screening information obtained by reading fund prospectus. Data on returns and AUM obtained from CRSP US Survivorship-Bias free Mutual Fund data.

6 Methodology We are interested in the portion of the MF return that is attributable to the SRI characteristics after accounting for traditional risk premiums. The SRI alpha Alpha = Actual Excess return Expected Excess return Modified Carhart 4 Factor Alpha (Crisis and Non-Crisis) R t R f,t = α NC D NC, t + α C D C, t + β 1 ( R m, t R f,t )+ β 2 SMB t + β 3 HML t + β 4 WML t

7 Methodology Crisis periods (S&P 500 peak to trough): 1)Technology bubble burst: March 2000 to October ) Financial Crisis: October 2007 to March 2009 Matched fund method to compare performance Bauer, Koedijk and Otten (2005), Bollen (2007), and Renneboog, Horst, and Zhang (2008). 3 Conventional Funds for every SRI fund

8 SRI Vs. Conventional Funds SRI - Conventional Full Non- Estimate Period Crisis Crisis Average Return [-0.13] [-1.19] [1.65] CAPM Alpha * 1.61** [-0.45] [-1.69] [2.03] FF3 Alpha * 1.70** [0.16] [-1.83] [2.38] Carhart 4 Factor Alpha * 1.66** [0.11] [-1.93] [2.32]

9 Types of SRI MFs Alcohol, Tobacco, Gambling ATG and other product screens (weapons, animal rights, pornography, ) ESG Environmental Social Governance Shareholder advocacy Faith / Religion

10 Screening Foci No Prospect Theory Effect SRI - Conventional Average Full Non- Average TNA Period Crisis Crisis Fund Type # Funds ($ in Millions) α α (NC) α ( C ) Only ATG Screens [ATG_ONLY] [-0.04] [0.93] [-0.64] Only Product Screens [PROD_ONLY] [0.47] [1.43] [-0.42] Any ESG Screens [ESG] ** 2.18** [0.13] [-2.39] [2.50] Environmental Screens [ENV] *** 2.21** [-0.08] [-2.83] [2.33] Social Screens [SOC] ** [0.28] [-1.54] [2.01] Governance Screens [GOV] *** [1.11] [-0.76] [2.77] Shareholder Advocacy [SHR_ADV] ** [0.16] [-1.45] [2.07] Faith/Religion Based [REL] * [0.58] [1.73] [-0.88]

11 Screening Foci Prospect Theory Pattern SRI - Conventional Average Full Non- Average TNA Period Crisis Crisis Fund Type # Funds ($ in Millions) α α (NC) α ( C ) Only ATG Screens [ATG_ONLY] [-0.04] [0.93] [-0.64] Only Product Screens [PROD_ONLY] [0.47] [1.43] [-0.42] Any ESG Screens [ESG] ** 2.18** [0.13] [-2.39] [2.50] Environmental Screens [ENV] *** 2.21** [-0.08] [-2.83] [2.33] Social Screens [SOC] ** [0.28] [-1.54] [2.01] Governance Screens [GOV] *** [1.11] [-0.76] [2.77] Shareholder Advocacy [SHR_ADV] ** [0.16] [-1.45] [2.07] Faith/Religion Based [REL] * [0.58] [1.73] [-0.88]

12 SRI Styles Negative Screens Weed out the products and practices that are unwanted Positive Screens Seek out the products and practices that are wanted

13 SRI - Conventional Average Full Non- Average Assets Period Crisis Crisis Fund Type # Funds ($ in Millions) α α (NC) α ( C ) Only Product Screens [PRODUCT] [0.47] [1.43] [-0.42] Any ESG: Positive Screening [ESG_POS] *** 2.80** [-0.05] [-2.98] [2.58] Negative Screening [ESG_NEG] [1.12] [1.00] [0.61] Environment: Positive Screen [ENV_POS] *** 2.25** [-0.21] [-3.03] [2.14] Negative Screen [ENV_NEG] [0.35] [-0.12] [0.96] Social: Positive Screen [SOC_POS] * 2.79** [0.50] [-1.84] [2.50] Negative Screen [SOC_NEG] [-0.46] [0.25] [-1.18] Governance: Positive Screen [GOV_POS] *** [1.11] [-1.13] [3.00] Negative Screen [GOV_NEG] [0.30] [1.02] [-0.85] Screening Strategies Positive Screens show the Prospect Theory pattern

14 What if the pattern is due to the other company characteristics? SRI firms tend to be: Younger Growth firms Smaller Lower leverage etc.

15 What if the pattern is due to characteristics of the mutual fund? MF portfolio Number of stocks Defensive tilt Turnover

16 Stock and Fund Level Characteristics Factor models do not specifically look at the stock and fund level characteristics. Panel data analysis of quarterly data of fund returns: R j,t R f,t = α 1 + α 2 SRI j + α 3 SRI j Crisis t + β 1 ( R m, t R f,t ) + δ 1 Age j,t + δ 2 BM j,t + δ 3 Cap j,t + δ 4 Leverage j,t + δ 5 Turnover j,t + δ 6 Div Yield j,t + δ 7 Ret Vol j,t + δ 8 CF Vol j,t + δ 9 ROA j,t + δ 10 Fund # Stks j,t + δ 11 Fund Defensive Alloc j,t + δ 12 Fund Turnover j,t Alpha and risk control

17 Stock and Fund Level Characteristics Factor models do not specifically look at the stock and fund level characteristics. Panel data analysis of quarterly data of fund returns: R j,t R f,t = α 1 + α 2 SRI j + α 3 SRI j Crisis t + β 1 ( R m, t R f,t ) + δ 1 Age j,t + δ 2 BM j,t + δ 3 Cap j,t + δ 4 Leverage j,t + δ 5 Turnover j,t + δ 6 Div Yield j,t + δ 7 Ret Vol j,t + δ 8 CF Vol j,t + δ 9 ROA j,t + δ 10 Fund # Stks j,t + δ 11 Fund Defensive Alloc j,t + δ 12 Fund Turnover j,t Company Characteristics

18 Stock and Fund Level Characteristics Factor models do not specifically look at the stock and fund level characteristics. Panel data analysis of quarterly data of fund returns: R j,t R f,t = α 1 + α 2 SRI j + α 3 SRI j Crisis t + β 1 ( R m, t R f,t ) + δ 1 Age j,t + δ 2 BM j,t + δ 3 Cap j,t + δ 4 Leverage j,t + δ 5 Turnover j,t + δ 6 Div Yield j,t + δ 7 Ret Vol j,t + δ 8 CF Vol j,t + δ 9 ROA j,t + δ 10 Fund # Stks j,t + δ 11 Fund Defensive Alloc j,t + δ 12 Fund Turnover j,t Fund Characteristics

19 Panel Data: SRI & Foci [1] [2] [3] [4] [5] Independent ESG= ESG= ESG= ESG= Variables ESG_Any ESG_Env ESG_Soc ESG_Gov SRI * [-1.78] SRI * CRISIS 0.781* [1.78] ESG * * [-1.76] [-1.89] [-1.48] [-1.60] ESG * CRISIS 0.900** 0.895** 1.037** 1.124** [1.98] [1.99] [2.05] [2.29] PROD_ONLY [-0.96] [-1.02] [-0.78] [-0.70] PROD_ONLY * CRISIS [0.85] [0.84] [0.83] [0.80] Intercept & Other Variables Suppresed Observations 11,638 11,638 11,638 11,638 11,638 R-squared

20 Panel Data: SRI & Foci [1] [2] [3] [4] [5] Independent ESG= ESG= ESG= ESG= Variables ESG_Any ESG_Env ESG_Soc ESG_Gov SRI * [-1.78] SRI * CRISIS 0.781* [1.78] ESG * * [-1.76] [-1.89] [-1.48] [-1.60] ESG * CRISIS 0.900** 0.895** 1.037** 1.124** [1.98] [1.99] [2.05] [2.29] PROD_ONLY [-0.96] [-1.02] [-0.78] [-0.70] PROD_ONLY * CRISIS [0.85] [0.84] [0.83] [0.80] Intercept & Other Variables Suppresed Observations 11,638 11,638 11,638 11,638 11,638 R-squared

21 Panel Data: SRI & Foci [1] [2] [3] [4] [5] Independent ESG= ESG= ESG= ESG= Variables ESG_Any ESG_Env ESG_Soc ESG_Gov SRI * [-1.78] SRI * CRISIS 0.781* [1.78] ESG * * [-1.76] [-1.89] [-1.48] [-1.60] ESG * CRISIS 0.900** 0.895** 1.037** 1.124** [1.98] [1.99] [2.05] [2.29] PROD_ONLY [-0.96] [-1.02] [-0.78] [-0.70] PROD_ONLY * CRISIS [0.85] [0.84] [0.83] [0.80] Intercept & Other Variables Suppresed Observations 11,638 11,638 11,638 11,638 11,638 R-squared

22 We can do a similar analysis for Positive versus Negative screens, while controlling for stock and fund characteristics

23 Panel Data: SRI & Screening [1] [2] [3] [4] Independent ESG= ESG= ESG= ESG= Variables ESG_Any ESG_Env ESG_Soc ESG_Gov POSITIVE_ESG * * * * [-1.82] [-1.84] [-1.71] [-1.94] POSITIVE_ESG * CRISIS 1.150** 0.936* 1.186** 1.161** [2.26] [1.94] [2.12] [2.29] NEGATIVE_ESG [0.03] [-0.16] [-0.88] [-1.11] NEGATIVE_ESG * CRISIS [1.53] [1.53] [0.18] [0.78] PROD_ONLY [-0.56] [-0.57] [0.39] [0.56] PROD_ONLY * CRISIS [-0.48] [-0.47] [0.25] [-0.08] 1.004*** 1.005*** 1.004*** 1.004*** Intercept & Other Variables Suppresed Observations 11,638 11,638 11,638 11,638 R-squared

24 Conclusions Compared to conventional mutual funds, SR mutual funds outperform during periods of market crisis. This dampening of downside risk comes at the cost of underperforming during non-market crisis. Investors with Prospect Theory utility functions would value the skewness of these returns. Asymmetric return pattern for SR funds is driven by the mutual funds that focus on environmental, social, and governance (ESG) attributes. The pattern is especially pronounced in the ESG funds that use positive screen techniques. Pattern can be attributed to the socially responsible attributes and not the differences in fund management or the characteristics of the companies in the portfolios.