Socially Responsible Investments: Methodology, Risk Exposure and Performance

Transcription

1 Socially Responsible Invesmens: Mehodology, Risk Exposue and Pefomance Finance Woking Pape N. 175/2007 June 2007 Luc Renneboog Tilbug Univesiy and ECGI Jenke e Hos Tilbug Univesiy Chendi Zhang Univesiy of Sheffield Luc Renneboog, Jenke e Hos and Chendi Zhang All ighs eseved. Sho secions of ex, no o exceed wo paagaphs, may be quoed wihou explici pemission povided ha full cedi, including noice, is given o he souce. This pape can be downloaded wihou chage fom: hp://ssn.com/absac_id=

2 ECGI Woking Pape Seies in Finance Socially Responsible Invesmens: Mehodology, Risk Exposue and Pefomance Woking Pape N. 175/2007 June 2007 Luc Renneboog Jenke e Hos Chendi Zhang Luc Renneboog, Jenke e Hos and Chendi Zhang All ighs eseved. Sho secions of ex, no o exceed wo paagaphs, may be quoed wihou explici pemission povided ha full cedi, including noice, is given o he souce.

3 Absac This pape suveys he lieaue on socially esponsible invesmens (SRI). Ove he pas decade, SRI has expeienced an explosive gowh aound he wold. Paicula o he SRI funds is ha boh financial goals and social objecives ae pusued. While copoae social esponsibiliy (CSR) - defined as good copoae govenance, sound envionmenal sandads, and good managemen owads sakeholde elaions - may ceae value fo shaeholdes, paicipaing in ohe social and ehical issues is likely o desoy shaeholde value. Fuhemoe, he isk-adjused euns of SRI funds in he US and UK ae no significanly diffeen fom hose of convenional funds, wheeas SRI funds in Coninenal Euope and Asia-Pacific songly undepefom benchmak pofolios. Finally, he volailiy of money-flows is lowe in SRI funds han of convenional funds, and SRI invesos decisions o inves in an SRI fund ae less affeced by managemen fees han he decisions by convenional fund invesos. Keywods: socially esponsible invesmens, ehical invesing, copoae social esponsibiliy, muual funds, pefomance evaluaion, money-fl ows, invesmen sceens, muual funds. JEL Classificaions: A13, G11, G12 Luc Renneboog Depamen of Finance and CenER Tilbug Univesiy P.O. Box LE Tilbug he Nehelands phone: , fax: [email protected] Jenke e Hos Depamen of Finance and CenER Tilbug Univesiy P.O. Box LE Tilbug he Nehelands [email protected] Chendi Zhang* Managemen School Univesiy of Sheffi eld Sheffield UK [email protected] *Coesponding Auho

4 1. Inoducion Ove he pas decade, socially esponsible invesmens (SRI), ofen also called ehical invesmens o susainable invesmens, have gown apidly aound he wold and become a muli-illion dolla make. SRI can be defined boadly as an invesmen pocess ha consides he social and envionmenal consequences of invesmens, boh posiive and negaive, wihin he conex of igoous financial analysis (Social Invesmen Foum (SIF), 2001:4). Unlike convenional ypes of invesmens, SRI funds apply a se of invesmen sceens o selec socks fom an invesmen univese based on social, envionmenal o ehical (SEE) cieia. This pape suveys he lieaue on socially esponsible invesmens. In he fis pa of he pape, we eview he insiuional backgound of ehical invesing. In paicula, we sudy he hisoical oos, he make developmen, he egulaoy backgound, and he invesmen sceens employed in SRI. While ehical invesing has ancien oigins and is ooed in eligious adiions, moden SRI is based on gowing social awaeness. Issues like envionmen poecion, human ighs and copoae govenance have become common in he invesmen sceens used by SRI. Cuenly, socially sceened asses epesen abou 10% of he oal asses unde managemen in he US. Fuhemoe, in ecen yeas, govenmens in wesen counies have aken many egulaoy iniiaives egading SRI. Fo insance, he UK was he fis couny ha egulaed he disclosue of social, envionmenal o ehical invesmen policies by pension funds and chaiies. Second, we inoduce he lieaue on copoae social esponsibiliy (CSR). A he hea of SRI is a fundamenal quesion: is a fim s aim o maximize shaeholde value o sakeholde value? While in compeiive and complee makes hee is no conflic beween hese wo objecives, in pacice he maximizaion of shaeholde value ofen conflics wih he sakeholde value cieion due o he exisence of economic exenaliies. In he pape, we define copoae social esponsibiliy as a combinaion of good copoae govenance, sound envionmenal sandads, and cae of sakeholde elaions. We will pesen he empiical findings on he impac of each of hese hee componens on shaeholde value. In geneal, he lieaue shows ha CSR enhances shaeholde value. Thid, we eview he lieaue on pefomance evaluaion of muual funds. We evaluae muual fund pefomance fom he pespecive of a mean-vaiance inveso, and discuss he pefomance evaluaion echniques based on he CAPM and mulifaco models (e.g. Caha (1997)). We also discuss mehodologies using condiional saegies (e.g. Feson and Schad (1996)) and seemingly unelaed asses (e.g. Paso and Sambaugh (2002)) o evaluae fund pefomance. Fuhemoe, ess of makeiming abiliy and eun-based syle analysis ae discussed. Fouh, we pesen he empiical findings on he pefomance and money-flows of socially esponsible muual funds aound he wold. Fo SRI funds in he US and UK, hee is lile evidence ha he isk-adjused euns of SRI funds ae diffeen fom hose of convenional funds (see, e.g., Baue, 1

5 Koedijk and Oen (2005)). Howeve, SRI funds in Coninenal Euope and Asia-Pacific show song undepefomance elaive o benchmak pofolios. Fuhemoe, while SRI invesos chase pas pefomance, hei decision o inves in an SRI fund is less affeced by managemen fees and funds isk han he decision of convenional fund invesos (Renneboog, Te Hos, and Zhang (2006)). Also, he volailiy of money-flows is lowe in SRI funds han in convenional funds (Bollen (2006)). The emainde of he pape is oganized as follows. Secion 2 pesens he insiuional backgound of SRI. Secion 3 eviews he heoeical lieaue on and he empiical fim-level analyses of copoae social esponsibiliy. Secion 4 eviews he economeic echniques employed in pofolio pefomance evaluaion, and Secion 5 inoduces he empiical findings of he lieaue on he pefomance and money-flows of SRI muual funds. Secion 6 concludes. 2. Insiuional Backgound of SRI 2.1 Hisoy of SRI Ehical invesing has ancien oigins and is ooed in Jewish, Chisian, and Islamic adiions. Judaism has a wealh of eachings on how o use money ehically 1, and in medieval Chisian imes, hee wee ehical esicions on loans and invesmens which wee based on he Old Tesamen 2. The Caholic Chuch imposed a univesal pohibiion on usuy in 1139, which had no been elaxed unil he 19 h cenuy. In England, a law called The Ac Agains Usuy which pohibied excessive ineess on loans was in effec fom 1571 o 1624 (Glaese and Scheinkman (1998), and Lewison (1999)) 3. In he 17 h cenuy, he Quakes ( Sociey of Fiends ) efused o pofi fom he weapons and slaves ade when hey seled in Noh Ameica. The founde of Mehodism, John Wesley ( ), saed in his semon The Use of Money ha people should no engage in sinful ade o pofi fom exploiing ohes. The Mehodis Chuch in he UK avoided invesing in sinful companies, such as companies involved in alcohol, obacco, weapons and gambling, when hey began invesing in he sock make in 1920s. Based on he eachings of he Koan and is inepeaions, Islamic invesos avoid invesing in companies involved in pok poducion, ponogaphy, gambling, and in inees-based financial insiuions. 1 See, e.g., Maimonides, Mishneh Toah, Laws of Gifs o he Poo 10:7: "Thee ae eigh degees of zedakah (igheous giving), one above he ohe. The highes degee is o senghen he hand of a poo peson by making a gif o a loan, o eneing ino a paneship, o finding wok fo him/he, so ha hey become self-sufficien". In Toah, Leviicus 19:9-10 "When you eap he haves of you land, you shall no eap all he way o he edges of he field, o gahe he gleanings of you haves You shall leave hem fo he poo and he sange." and Deueonomy 15:7-8 "If hee be among you a needy peson you shall no shu you hand fom him/he; bu you shall suely open you hand and shall suely lend sufficien fo his/he need, as o ha which is lacking". 2 See, e.g., Exodus 22:25 If you lend money o my people, o he poo among you, you ae no o ac as a cedio o him; you shall no chage him inees and Deueonomy 23:19 "You shall no chage inees o you counymen: inees on money, food, o anyhing ha may be loaned a inees; bu you may chage inees fom loans o foeignes". 3 Duing he eign of Heny VIII ( ), usuy was defined as a loan wih inees ae highe han 10%. 2

6 Moden SRI is based on gowing social awaeness of invesos. Since he 1960s, a seies of social campaigns, e.g. he ani-wa and he ani-acis movemens, have made invesos concened abou he social consequences of hei invesmens. The fis moden SRI muual fund 4, he Pax Wold Fund, was founded in 1971 in he US. Ceaed fo invesos opposed o he Vienam Wa (and miliaism in geneal), he fund avoided invesmens in weapons conacos. In he 1980s, he acis sysem of apaheid in Souh Afica became a focal poin of poess by social invesos. SRI invesos in he US pessuized companies doing business in Souh Afica o dive hose opeaions o ohe counies, and uged muual funds no o include Souh-Afican no wesen fims wih Souh-Afican subsidiaies ino hei pofolios. These campaigns wee elaively successful, fo insance, he sae legislaue of Califonia passed a law amendmen in 1986 equiing he sae s pension funds o dives ove $6 billion fom companies wih aciviies in Souh Afica (Spakes, 2002: 54). On Apil 25 h, 1986 he Chenobyl nuclea powe plan in he fome Sovie Union (now Ukaine) exploded duing a es, speading adioacive maeial acoss Euope and inceasing he numbe of cance deahs by ove On Mach 23 h, 1989 he wos envionmenal disase in he US occued when he oil supeanke Exxon Valdez an agound nea Alaska and spilled 11 million gallons of cude oil. The above and ohe envionmenal disases in he lae 1980s made invesos awae of he negaive envionmenal consequences of indusial developmen. Since he ealy 1990s, he SRI indusy has expeienced song gowh in he US, Euope, and he es of he wold. An impoan faco behind his gowh was ehical consumeism, whee consumes pay a pemium fo poducs ha ae consisen wih hei pesonal values. Issues like envionmen poecion, human ighs, and labo elaions have become common in he SRI invesmen sceens. In ecen yeas, a seies of copoae scandals has uned copoae govenance and esponsibiliy ino anohe focal poin of SRI invesos. Hence, cieia like anspaency, govenance and susainabiliy have emeged as essenial SRI sceens. 2.2 The Make of SRI Ove he pas decade, socially esponsible invesmens have expeienced a phenomenal gowh aound he wold. Table 1 pesens he oal asses unde managemen (AUM) of SRI sceened pofolios and muual funds in he US, Euope, Canada and Ausalia. In he US, he pofessionally managed asses of socially sceened pofolios eached $2.3 illion in 2003, gowing by 1200% fom $162 billion in Cuenly, SRI asses epesen abou 10% of oal asses unde managemen in he US (SIF, 2005). Alhough he Euopean SRI make is sill in an ealy sage of developmen, i is also gowing apidly. In 2003, he asses of SRI sceened pofolios in Euope oaled aound 230 billion, and hey accoun fo abou 1% of oal asses unde pofessional managemen 4 The fis socially sceened muual fund, he Pionee Fund, was founded in This fund excluded invesmens in he alcohol and obacco indusies. 3

7 in Euope. The UK, he Nehelands and Belgium ae he counies wih he highes pecenage of socially sceened asses in Euope. In he US, he asses unde managemen of SRI funds 5 eached $138 billion in Fom 1995 o 2003, he numbe of SRI muual funds gew fom 55 o 178 in he US (SIF, 2003), fom 54 o 313 in Euope (SiRi, 2003), and fom 10 o 63 in Ausalia (EIA, 2003). [Inse Table 1 abou hee] I is someimes agued ha invesos in ehical funds ae willing o sacifice financial euns in ode o comply wih hei social o envionmenal objecives. The fac ha SRI invesos may have a diffeen invesmen objecive funcion is suggesed by he SIF (2001) epo: duing he sock make downun ove he fis 9 monhs of 2001, hee was a 94% dop in he money inflows ino all US muual funds. In conas, he fall in ne invesmens in socially sceened muual funds amouned o meely 54%. The SIF (2003, p.8) saes, Typically, social invesos asses ae sickie han hose of invesos concened only wih financial pefomance. Tha is, social invesos have been less likely o move invesmens fom one fund o anohe and have been moe inclined o say wih hei funds han convenional invesos. In he foeseeable fuue, he gowh of SRI asses is expeced o coninue woldwide. Some of he lages pension funds in he wold have shown inceasing inees in paicipaing in SRI. The Califonia Public Employees Reiemen Sysem (CALPERS), he lages pension fund in he wold, acively engages companies o pomoe socially esponsible behavio and was one of he leades of he obacco divesmen of he lae 1990s. The Duch Pension Fund fo Public Employees (ABP), he lages pension fund in Euope, evised is Code fo Puden Invesmen Policy in 2000, which saes ha ABP will pomoe he inegaion of SEE cieia in is invesmen pocess. M. Jean Fijns, he Chief Invesmen Office of ABP Invesmens, egads susainable invesmen as one of he mos ciical facos diving he fuue of fiduciay invesmen (Financial Times, Jan. 26, 2003). In addiion, he Duch pension fund PGGM, which manages abou 45 billion asses, applies wo negaive sceens (weapons poducion and human ighs violaion) o is invesmen pofolios (Euosif, 2003). 2.3 Regulaoy Backgound The gowh of he SRI indusy can be paly aibued o he changes in egulaion egading he disclosue of social, envionmenal and ehical (SEE) infomaion by pension funds and lised companies. In his secion, we eview he egulaoy iniiaives aken by naional govenmens egading SRI and summaize hese in Table 2. Mos of he SRI egulaion is passed in Euope. [Inse Table 2 abou hee] 5 SRI funds o socially esponsible invesmen muual funds, a subse of socially sceened pofolios, efe o he muual funds applying SRI sceens in hei invesmen pocess. 4

8 a. UK The UK was he fis couny ha egulaed he disclosue of SEE invesmen policies of pension funds and chaiies. This has conibued consideably o he gowh of SRI indusy. In July 2000, he Amendmen o he 1995 Pensions Ac was appoved, equiing usees of occupaional pension funds o disclose in he Saemen of Invesmen Pinciples he exen (if a all) o which social, envionmenal and ehical consideaions ae aken ino accoun in he selecion, eenion and ealizaion of invesmens. The Tusee Ac 2000, which came ino effec in Febuay 2001, equies chaiy usees o ensue ha invesmens ae suiable o a chaiy s saed aims. Accoding o he Chaiy Commission guidance, chaiies should include any elevan ehical consideaions as o he kind of invesmens ha ae appopiae fo he us o make. In 2002, The Cabine Office in he UK published he Review of Chaiy Law in 2002, which poposed ha all chaiies wih an annual income of ove 1 million epo on he exen o which SEE issues ae aken ino accoun in hei invesmen policies. The Home Office acceped heses ecommendaions in In addiion, lage oganizaions of insiuional invesos also have aken SRI iniiaives. Fo insance, he Associaion of Biish Insues (ABI), whose membes inves in abou $1 illion asses, published a disclosue guideline in 2001 suggesing ha lised companies epo on maeial SEE isks elevan o hei business aciviies. b. Coninenal Euope Ove he pas decade, some naional govenmens in coninenal Euope passed a seies of egulaions egading social and envionmenal invesmens and savings. Since 1991, he Renewable Enegy Ac in Gemany gives a ax advanage fo closed-end funds o inves in wind enegy (Euosif, 2003). In 1995, he Duch Tax Office inoduced Geen Savings and Invesmen Plan, which gans a ax deducion o invesmens in specific geen pojecs, such as wind and sola enegy, and oganic faming. Following he Biish Amendmen o he 1995 Pensions Ac of 2000, fou counies in Coninenal Euope (namely Belgium, Gemany, Ialy and Sweden) have passed simila egulaions equiing pension funds o disclose SEE elaed infomaion. In 2001, Belgium passed he Vandeboucke law, which equies pension funds o epo he degee o which hei invesmens ake ino accoun social, ehical and envionmenal aspecs. In Januay 2002, Gemany adoped a egulaion equiing ha ceified pivae pension schemes and occupaional pension schemes mus infom he membes in wiing, whehe and in wha fom ehical, social, o ecological aspecs ae aken ino consideaion when invesing he paid-in conibuions (Euosif, 2003). Sweden passed a egulaion (effecive since Januay 2002), equiing Swedish naional pension funds o incopoae envionmenal and ehical aspecs in hei invesmen policies. In Ialy, a legislaion was adoped in Sepembe 2004 equiing pension funds o disclose he effec of non-financial facos (including social, envionmenal and ehical facos) ha influence hei 5

9 invesmen decisions. All hese iniiaives, have clealy had a posiive impac on he gowh of he SRI fund indusy in Euope. Fance is he fis and so-fa he only Euopean couny making SEE epoing mandaoy fo all lised companies. In May 2001, he legislaion New Economic Regulaions came ino foce: lised companies ae o publish social and envionmenal infomaion on he companies in hei annual epos 6. Meanwhile, since Febuay 2001, he manages of Employee Savings Plans ae equied o conside social, envionmenal o ehical issues when buying and selling shaes 7. c. Ouside Euope In he US, secion 406 of he Sabanes-Oxley Ac (July 2002), equies companies o disclose a wien code of ehics signed by hei chief execuive, chief financial office and chief accounan. Ausalia is he only couny ouside Euope ha has adoped a egulaion egading SRI. In 2001, he Ausalian govenmen passed a bill equiing ha all invesmen fims poduc disclosue saemens include descipions of he exen o which labo sandads o envionmenal, social o ehical consideaions ae aken ino accoun. Since 2001, all lised companies on he Ausalian Sock Exchange ae obliged o make an annual social esponsibiliy epo. 2.4 Invesmen Sceens The invesmen sceens used in SRI have evolved ove ime. Table 3 pesens a summay of he SRI sceens used by ehical funds aound he wold. Usually, SRI muual funds apply a combinaion of he social sceens. SIF (2003) epos ha 64% of all socially sceened muual funds in he US use moe han five sceens, while 18% of SRI funds use only one sceen. These sceens can be boadly classified ino wo goups: negaive sceens and posiive ones. Fis, he oldes and mos basic SRI saegies ae based on negaive sceens. These files efe o he pacice ha ceain socks o indusies ae excluded fom SRI pofolios based on SEE cieia. The funds based on such sceens accoun fo $2.0 illion ou of he $2.15 illion SRI asses in he US (SIF, 2003). A ypical negaive sceen can be applied on an iniial asse pool such as he S&P 500 socks fom which he alcohol, obacco, gambling and defense indusies, o companies wih poo pefomance in labo elaions and envionmen poecion ae excluded. Afe negaive SRI sceening, he pofolios ae ceaed hough financial and quaniaive selecion. The mos common negaive sceens exclude obacco, 6 Law No , A : [The annual epo] also conains infomaion, he deail of which is being deemined by a decee of he Council of Sae, on how he company akes ino accoun he social and envionmenal consequences of is aciviies. The pesen paagaph applies only o ( lised ) companies [...]." ( 7 Law No , A : "The [fund's] inenal ules specify, if need be, he social, envionmenal o ehical consideaions he fund managemen company mus ake ino accoun when buying o selling secuiies, as well as when execising he voing ighs aached o he owneship of hese secuiies. The fund's annual epo epos on how hese consideaions have been aken ino accoun, in ems defined by he Commission des Opéaions de Bouse. " 6

10 alcohol, gambling, weapons and nuclea powe. Ohe negaive sceens may include iesponsible foeign opeaions, ponogaphy, aboion, wokplace condiions, violaion of human ighs, and animal esing. Some SRI funds only exclude companies fom he invesmen univese when hei evenue deived fom a-social o un-ehical secos exceed a specific heshold, while ohe SRI funds apply he negaive sceens o he company s banches o supplies. A small numbe of SRI funds use sceens based on adiional ideological of eligious convicions: fo insance hey exclude invesmens in fims poducing pok poducs, in financial insiuions paying inees on savings, and even in insuance companies insuing non-maied people 8. [Inse Table 3 abou hee] Second, SRI pofolios ae nowadays mosly based on posiive sceens, which in pacice boils down o selecing shaes ha mee supeio SEE sandads. The mos common posiive sceens focus on copoae govenance, labo elaions, he envionmen, susainabiliy of invesmens, and he simulaion of culual divesiy. Posiive sceens ae also fequenly used o selec companies wih a good ack ecods concening enewable enegy usage o communiy involvemen. The use of posiive sceens is ofen combined wih a bes in class appoach. Fims ae anked wihin each indusy o make seco based on SEE cieia. Subsequenly, fo each indusy only hose fims ae seleced which pass a minimum heshold. Negaive and posiive sceens ae ofen efeed o as he fis and second geneaion of SRI sceens especively. The hid geneaion of sceens efes o an inegaed appoach of selecing companies based on he economic, envionmenal and social cieia compised by boh negaive and posiive sceens. This appoach is ofen called susainabiliy o "iple boom line" (due o is focus on People, Plane and Pofi ). The fouh geneaion of ehical funds combines he susainable invesing appoach (hid geneaion) wih shaeholde acivism and commimen. In his case, pofolio manages o he companies specialized in ganing ehical labels aemp o influence he company s acions hough diec dialogue wih he managemen o by he use of voing ighs a Annual Geneal Meeings. SIF (2003) epos ha in 2002 socially esponsible invesos in he US filed 292 shaeholde esoluions on SEE issues. The lages numbe of esoluions is on envionmenal issues, followed by issues on global labo sandads and equal employmen condiions. 3 Fim-level Analysis on SRI In his secion, we inoduce he findings of fim-level sudies elaed o socially esponsible invesmens. While Secion 3.1 suveys he heoeical agumens, Secion 3.2 focuses on he empiical evidence. 8 These SRI funds ae usually small which in oal manage less han $100 million of asses in he US. 7

11 3.1 Theoeical Backgound: Should Companies Be Socially Responsible? Finance exbooks sae ha companies should maximize he value of hei shaeholdes equiy 9. In ohe wods, companies only esponsibiliy is a financial one. In ecen yeas, copoae social esponsibiliy (CSR) has become a focal poin of policy makes (and invesos), who demand ha copoaions assume some esponsibiliy owads sociey, he envionmen, o he sakeholdes in geneal. SRI invesos hus aim a pomoing socially and envionmenally sound copoae behavio. They avoid companies poducing goods ha may cause healh hazads o exploiing employees boh in developed and developing counies (negaive sceening) and selec companies wih sound social and envionmenal ecods and wih good copoae govenance (posiive sceening). In geneal, SRI invesos expec companies o focus on social welfae in addiion o value maximizaion. a. Shaeholde value vs. Sakeholde value A he hea of he SRI movemen is a fundamenal quesion: is a fim s aim o maximize shaeholde value o social value (defined as he sum of he value geneaed fo all sakeholdes)? Classical economics (e.g. Adam Smih s invisible hand and he social welfae heoems) saes ha hee is no conflic beween he wo goals: in compeiive and complee makes, when all fims maximize hei own pofis (value), he esouce allocaion is Paeo-opimal and he social welfae is maximized. Howeve, moden economic heoy also ells us ha in some cicumsances, namely when some of he assumpions of he welfae heoems do no hold, pofi-maximizing behavio does no necessaily imply social-welfae maximizing oucomes. One of such cicumsances is he exisence of exenaliies, aising when he coss and benefis of an agen s acion ae affeced by he acions of ohe (exenal) agens. Jensen (2001) gives a simple example of exenaliies: a fishey s cach is impaied by he polluion of an upseam chemical plan. When he chemical plan maximizes is pofi by inceasing polluion (as he cos of polluion ae no bone by he chemical plan), he fishey in he downseam suffes fom caching less fish and he social welfae (in his simplified case, equal o he sum of he pofis of he wo sakeholdes) is no maximized. Economic soluions o he exenaliy poblem include he imposiion of egulaion (e.g. quoas o axes on polluion) and he ceaion of a make fo exenaliies (e.g. he ading of polluion pemis). In pacice, he maximizaion of shaeholde value ofen conflics wih he social welfae cieion epesened by he ineess of all sakeholdes of a fim, including employees, cusomes, local communiies, envionmen and so foh. In Coninenal Euopean 9 Value is he pesen value of fuue pofis ove he long un, and i is no necessaily he cuen make value of he fim, as makes can be iaional. Jensen (2004) agues ha ovevalued equiy ceaes addiional agency coss, which will ineviably lead o he desucion of fim value ove he long un. Theefoe, manages should egulaly communicae wih capial makes o peven no only undevaluaion bu also ovevaluaion. 8

12 copoae govenance egimes, a sakeholde appoach is moe common han in he Anglo-Saxon counies. 10 b. The poblems of he sakeholde heoy and implicaions fo SRI Accoding o he shaeholde value heoy, manages ae expeced o inves unil he maginal pojec s eun exceeds he cos of capial. In he sakeholde value concep, manages ae asked o balance he ineess of all sakeholdes such ha he aggegae welfae is maximized. Bu he sakeholde concep does no define how o aggegae welfae and how o make he adeoff beween sakeholdes. If he social value of fims can be maximized, he sociey will by definiion benefi. Howeve, he quesion is whehe o no his goal is achievable and how economic efficiency and manageial incenives ae affeced by he maximizaion of sakeholde value (including social and envionmenal value). Jensen (2001: 14) wies, i is he failue o povide a cieion fo making such adeoffs (among sakeholdes), o even o acknowledge he need fo hem, ha makes sakeholde heoy a pescipion fo desoying fim value and educing social welfae. Given ha he objecive funcion of a manage is no well defined in sakeholde heoy, he pefomance of manages becomes unaccounable. Jensen (2001) agues ha he sakeholde heoy inceases he agency coss and weakens he inenal conol sysems of fims, because pefomance measues ae only vaguely descibed. Similaly, Tiole (2001: 26) wies, In a nushell, managemen can almos always aionalize any acion by invoking is impac on he welfae of some sakeholde. An empie builde can jusify a cosly acquisiion by a claim ha he puchase will save a couple of jobs in he acquied fim; a manage can choose his bohe-in-law as supplie on he gounds ha he lae s poducion pocess is envionmenally fiendly. In addiion, Tiole (2001) shows ha he absence of a eliable pefomance measue leads o fla ahe han pefomance-based - manageial compensaion conacs, which fuhe weakens manageial incenives. Anohe poblem of he sakeholde appoach is ha in a compeiive make, a fim loweing is pofis in ode o pusue social and envionmenal goals may no suvive compeiion o disciplinay acions by he make fo copoae conol. The eason is ha anohe company can acquie his fim and eplace he incumben managemen wih a value-maximizing one (Tiole (2001: 24)). To conclude, in ode fo copoae social esponsibiliy o become a wokable concep, he following guidelines of pefomance yadsicks should be adoped: (1) Copoae pefomance mus be measuable. Lack of pecisely fomulaed copoae goals and measues desoy fim value and social welfae in he long un. Fim value emains he single mos impoan pefomance measue fo managemen. 10 In Gemany, fo insance, he impoance of sakeholdes is even legally defined. Geman law mandaes ha he supevisoy boad is made up of epesenaives of he employees and unions, while he ohe half of he boad consiss of epesenaives of he majo shaeholdes. 9

13 (2) Maximizing long-un fim value is in line wih maximizing social welfae. Tiole (2001) concludes ha focusing on shaeholde value is a second-bes opimum once manageial incenive poblems like agency coss have been incopoaed in a sakeholde famewok. (3) Even if one adops he shaeholde value cieion, i is impoan o conside he welfae of all sakeholdes (including employees, he communiy and he envionmen) as fim behavio induces impoan exenaliies. Jensen (2001) noes, we canno maximize he long-em make value of an oganizaion if we ignoe o misea any impoan consiuency (sakeholde). (4) Economic heoy pedics ha companies will be moe willing o sacifice pofis in ode o be socially esponsible, when hei managemen is enenched o shielded fom ani-akeove mechanisms. The eason is ha hese manages ae less likely o be eplaced by pofi-maximizing ones. c. The impac of SRI on fim behavio Given ha negaive sceening is he mos common pacice in SRI (see Secion 2.4), i is ineesing o sudy whehe o no his appoach achieves he goal of pomoing social esponsibiliy. In ohe wods, we ask he quesion whehe SRI affecs copoae behavio, o whehe he SRI s benefi is only a feelgood senimen ceaed by no being involved in unehical copoae behavio. To answe his quesion, Heinkel, Kause and Zechne (2001) developed a heoeical model ha capues he effecs of negaive SRI sceening on a polluing fim s economic behavio. The assumpions of his model ae: (i) invesos ae isk avese and consis of wo ypes: geen invesos and neual invesos, and (ii) each fim has one of wo echnologies: a clean echnology and a polluing one. The basic quesion is whehe he pesence of geen invesos can cause fims o ale hei copoae behavio, i.e. o change fom using a polluing echnology o a clean one. The model shows ha he quesion is answeed affimaively: if fund manages adop negaive sceens, polluing fims ae pesen in fewe invesmen pofolios, which educes iskshaing oppouniies among invesos. Hence, he sock pice of polluing fims falls, hus aising hei cos of capial (expeced eun). When he inceased cos of capial exceeds he cos of capial of socially esponsible fims (in his case, he ones which ansfeed o a less polluing echnology), polluing fims end o un moe envionmenally fiendly. In a follow-up pape, Banea, Heinkel and Kause (2005) invesigae he effecs of negaive polluion sceening on he invesmen decisions of polluing fims. The issue is examined in an equilibium seing wih endogenous invesmen decisions, i.e. fims ae allowed o choose he level of invesmen. The sudy concludes ha negaive sceening educes he incenives of polluing fims o inves, which lowes he oal level of invesmen in he economy. 3.2 Empiical Evidence: Which SRI Sceens Can Enhance Value? Given ha economic heoy ells us ha fims should be socially esponsible o he exen ha i helps maximizing fim value, he cucial quesion is which SRI sceens enhance fim value and which do no. In ohe wods, we ask he quesion which invesmen sceens ae likely o impove SRI fund 10

14 pefomance. We define copoae social esponsibiliy as he sum of good copoae govenance (poecing shaeholdes ineess), envionmenal efficiency (poecing envionmenal sakeholdes inees), and good sakeholde elaions (poecing he ineess of ohe sakeholdes, including hose of employees and he local communiy). In his subsecion, we eview he lieaue on he value-elevance of copoae social esponsibiliy, and y o idenify which of hese hee componens ae likely o be value dives. a. Copoae Govenance Sceening Copoae govenance addesses he conflics of ineess beween an agen (manage) and a pincipal (inveso). This conflic of inees is induced by he sepaaion of owneship and conol in he moden copoaion, and can bing abou impoan agency coss. Manages may exe insufficien effo in enhancing shaeholdes value (moal hazad), enjoy building copoae empies and exac pivae benefis of conol, o enench hemselves by ani-akeove povisions such ha (dispesed) shaeholdes ae no able o execise conol. These agency coss ae a odds wih he definiion of copoae govenance fomulaed by Shleife and Vishny (1997): copoae govenance consiss of he ways in which he supplies of finance o copoaions assue hemselves of geing a fai eun on hei invesmen. Tiole (2001) akes a boade view and defines copoae govenance as he design of insiuions ha induce o foce managemen o inenalize he welfae of sakeholdes. The empiical lieaue shows ha hee is a posiive elaion beween copoae govenance and a fim s value. Gompes, Ishii and Meick (2003) (heeafe GIM) sudy he elaion beween a se of 24 copoae-govenance (ani-akeove) povisions and a fim s long-un pefomance in he 1990s. Since he govenance sucues of a fim ae no exogenous, he pape makes no claim abou he diecion of causaliy beween govenance and pefomance, bu ahe analyzes whehe o no copoae govenance is associaed wih fim value. A siking elaion beween copoae govenance and sock euns is uncoveed: a saegy (i.e. an invesmen sceen) ha involves buying fims wih he songes shaeholde ighs and selling fims wih he weakes shaeholde ighs geneaes an annual abnomal eun of 8.5% ove he 1990s. The eun is measued by he Fama-Fench-Caha fou-faco model (see Secion 4.2). In addiion, he govenance index is highly coelaed wih fim value (measued by Tobin s Q). These findings can be inepeed as follows: (i) he sock make undeesimaes he agency coss induced by he copoae povisions ha educe shaeholde ighs, (ii) manages have pivae infomaion (no shaed wih invesos) ha fuue fim pefomance will be poo, so hey may use copoae povisions o enench hemselves and educe shaeholde ighs, (iii) he significan abnomal euns geneaed by copoae govenance sceening may be no due o make-inefficiency, bu ahe capue he pemium of some isk facos ha is missing in he cuen asse picing models. The GIM s appoach of defining copoae govenance as a se of ani-akeove povisions has limiaions. Cemes and Nai (2005) exend GIM s wok by classifying copoae govenance mechanisms ino exenal govenance (akeove vulneabiliy) and inenal govenance (he pesence of 11

15 insiuional blockholdes), and invesigae how he ineacion of hese wo govenance mechanisms is associaed wih equiy euns. In paicula, he auhos use wo poxies fo inenal govenance: he pecenage of shaes owned by insiuional blockholdes, and he pecenage of shaes owned by public pension funds. The pape finds ha inenal and exenal govenance ae complemens in elaion o sock euns: an invesmen saegy (sceen) based on shaeholde ighs (exenal govenance) geneaes an annualized abnomal eun of 10-15% when blockholde owneship is high (inenal govenance). Similaly, an invesmen saegy based on fim s inenal govenance mechanism yields annualized abnomal euns of 8% when exenal govenance mechanism is song (i.e. in fims wih few aniakeove povisions). I is ineesing o sudy if he same paen appeas in ohe copoae govenance egimes. Baue, Gunse and Oen (2004) apply he GIM mehodology o Euopean daa. Copoae govenance daa ae obained fom he Demino Copoae Govenance Raings, which coves 269 fims included in he FTSE Euoop 300 fo he yeas of 2000 and Fo he peiod , he govenance aings ae assumed o be consan ove ime. The auhos use he oveall govenance aings fom Demino, which ae he aggegaes of 300 cieia coveing shaeholde ighs, akeove defense, infomaion disclosue and boad sucue. The pape shows ha good copoae govenance leads o highe sock euns and highe fim value in Euope. In addiion, conay o he findings of GIM, he pape epos a negaive elaion beween copoae govenance sandads and eanings measues (like ROE). 11 b. Envionmenal Sceening Alhough simple economic logic suggess ha a singen envionmenal sandad can incease he poducion coss and hus hu copoae pofiabiliy, a gowing body of empiical lieaue epos a posiive elaion beween copoae envionmenal pefomance and fim value. Reseaches use vaious mehods o sudy he effec of envionmenal pefomance on value. Fis, an even sudy was pefomed o examine he infomaion conen of copoae news on envionmenal issues. Fo example, Klassen and McLaughlin (1996) find significan posiive abnomal euns afe a fim eceives envionmenal pefomance awads, and significan negaive euns afe an envionmenal cisis. Second, using Tobin s Q as a measue of fim value, some sudies invesigae if highe envionmenal sandads ae associaed wih a highe make value. Dowell, Ha and Yeung (2000) find ha US-based mulinaional enepises adoping a singen global envionmenal sandad have much highe make values han fims wih less singen sandads. Kona and Cohen (2001) decompose 11 While he above copoae govenance sudies focus on well-developed make economies such as he US and Euope, Claessens (1997) invesigaes he elaion beween copoae govenance and equiy pices in he conex of he ansiion of cenally planned economies o make economies. He epos ha he pices of pivaizaion vouches depend upon owneship sucues: he moe concenaed owneship, he highe he pices. Howeve, when an invesmen bank holds a elaively lage shae sake (which suggess conflics of ineess), he equiy (i.e. vouche) pices ae elaively low. 12

16 Tobin s Q ino angible asse value and inangible asse value and find ha poo envionmenal pefomance is negaively coelaed wih he inangible asse value. Thid, he empiical lieaue has ecenly begun o measue he elaion beween sock euns and envionmenal pefomance. Dewall, Gunse, Baue and Koedijk (2005) consuc equiy pofolios based on envionmenal pefomance cieia, namely he eco-efficiency scoes fom Innoves Saegic Value Advisos, and measue he pefomance of hese pofolios by he Fama-Fench-Caha fou-faco model (see Secion 4.2). A pofolio of fims wih high envionmenal scoes (based on posiive sceening) oupefoms a pofolio of fims wih low scoes by 6% pe annum ove he peiod The auhos give wo poenial explanaions: (i) he sock make undevalues he envionmenal infomaion, and (ii) he eco-efficiency pemium capues he pemium of some missing isk facos in asse picing models. c. Sakeholde Relaion Sceening The empiical sudies on copoae social esponsibiliy (CSR) have focused on he valuaion effec of CSR. Fo insance, Hillman and Keim (2001) invesigae he valuaion effec of CSR on make value added (MVA) which is he diffeence beween he make value of equiy and he book value of asses (Sewa, 1996). The auhos ague ha CSR consiss of wo componens: he fis (called sakeholde managemen ) efes o impoving he elaionships wih pimay sakeholdes like employees, cusomes, supplies and communiies, while he second efes o social issue paicipaion like a ban on nuclea enegy, avoidance of sin indusies (such as gambling, ponogaphy), and no doing business in counies wih bad human ighs ecods. Hillmann and Keim show ha managemen focusing on sakeholde value also ceae shaeholde value. In conas, social issue paicipaion ofen desoys shaeholde value. Fuhemoe, he exisence of a majo shaeholde may have an impac on he level of sakeholde managemen and social issue paicipaion of a company. Fo insance, majo shaeholdes ae visible o ousides and may heefoe become he age of social acivism. Using deailed owneship daa and daa on copoae social esponsibiliy of he S&P 500 fims, Goegen and Renneboog (2002) invesigae he impac of owneship on CSR bu fail o find a elaion beween conol concenaion and CSR. To conclude his subsecion, we summaize he empiical findings of copoae finance and saegy lieaue on copoae social esponsibiliy. The following componens of CSR can enhance shaeholde value and hus social welfae: good copoae govenance, sound envionmenal sandads, and cae of sakeholde elaions. Paicipaing in ohe social and ehical issues is likely o desoy fim value. 4 Pefomance Evaluaion of Muual Funds 13

17 In Secion 3 we have discussed fim-level evidence on copoae social esponsibiliy. Befoe inoducing empiical findings of pofolio-level sudies on socially esponsible invesmens in Secion 5, we eview he economeic mehodologies used o evaluae muual fund pefomance. 4.1 Mean-Vaiance Analysis Pefomance measuemen efes o he pacice of deecing whehe o no a fund manage has special skills o bea a passive benchmak pofolio. We evaluae muual fund pefomance fom a pofolio pespecive: an inveso desies o maximize he isk-adjused euns of his pofolio. a. Mean-Vaiance Opimizaion Conside a mean-vaiance opimizing inveso who cuenly invess in K isky asses. Le he expeced eun and he covaiance maix of he K-dimensional asse eun veco R be given by µ R and RR especively, and he veco of iniial pofolio weighs is denoed as w R. Fo a isk-avese inveso, he mean-vaiance objecive funcion in ems of ceainy equivalence (i.e. he expeced eun ha would make he inveso indiffeen fom a iskless eun), is: 1 CE = wr ' µ R γw' R RR wr (1) 2 whee is he inveso s consan elaive isk avesion (CRRA) coefficien (i is assumed ha >0). A mean-vaiance efficien pofolio is obained by maximizing Eq. (1) wih espec o w R subjec o he pofolio consain w' R ι K = 1, whee ιk is a K-dimensional veco of ones. I follows ha he opimal weighing veco w * R of he mean-vaiance pofolio is w * R -1 = γ 1 RR ( µ ηι ) R K (2) whee is he expeced eun on he zeo bea pofolio of he line angen o he mean-vaiance fonie a * w R, which can be obained as he inecep of * w R (in he mean-sandad deviaion space). Because of he consain w' ι = 1, i is saighfowad o show fom Eq. (2) ha he zeo bea ae depends on R K he isk avesion coefficien. This implies ha each mean-vaiance efficien pofolio * w R is uniquely deemined when eihe o is known. The zeo bea ae also equals he invese of he expecaion of a sochasic discoun faco (Cochane (2001:108)). Noe ha when hee exiss a isk fee asse in he economy, he zeo bea ae fo evey inveso can be eplaced by he isk-fee ae as he mean-vaiance fonie becomes a saigh line. We now conside he case when an inveso exends he iniial se of K asses by adding a se of N muual funds. The expeced eun and he covaiance maix of he N-dimensional fund eun veco is 14

18 denoed by µ and especively, and he covaiance maix wih he se of iniial asses is given by R. Below, he vaiables efeing o he euns of iniial asses (R ) and muual funds ( ) ae labeled wih subscip R and, especively. Vaiables ha efe o he lage eun se (R, ) do no have a subscip. Thus, he K+N dimensional weigh veco of he exended se is efeed o as w. If he inveso canno exend he mean-vaiance fonie by invesing in he se of N muual funds, he opimal weigh on each of he N muual funds would be zeo. In his case, he exended opimal weigh veco w * of he K+N asses is w * = 0 * w R N = γ 1 RR R R 1 µ R ηιk µ ηι N (3) whee 0 N is a N dimensional veco of zeos. Subsiuing (2) ino (3) gives ( µ = (4) whee B ηι N ) B( µ R ηιk ) 0 N R 1 RR is an N K maix (see Te Hos (1998: 40)). If Eq. (4) is valid, he opimal pofolio weigh in he K+N asses coincides wih he iniial opional weigh in K asses. In his case, i suggess ha he wo mean-vaiance fonies will inesec a he inveso s iniial pofolio locaion. b. Genealized Jensen s alpha Eq. (4) has impoan implicaions fo he pefomance measuemen of muual funds. The lef hand side of Eq. (4), α J ( η) ( µ ηι N ) B( µ R ηι K ) (5), genealizes he oiginal Jensen s alpha poposed by Jensen (1968). The oiginal alpha-measue equies ha an inveso s benchmak asses ae a isk fee deposi and he make pofolio (see Secion 4.2 fo deails). In ha case he zeo bea ae is equal o he isk fee ae. In conas, he genealized alpha-measue α J (η ) does no assume ha invesos iniially hold a isk fee deposi and he make pofolio. α J (η ) depends on he zeo bea ae and hus he isk avesion coefficien. A posiive α J (η ) indicaes ha he coesponding muual fund oupefoms he benchmak asses, while a negaive one deecs undepefomance of he muual fund. I is saighfowad o show ha an inveso who holds he K benchmak asses can exend he meanvaiance fonie by aking a long posiion in a fund wih a posiive α J (η ) and a sho posiion in a fund wih a negaive α J (η ). When he genealized Jensen s alpha equals zeo (i.e. Eq. (4) holds), i is impoan o disinguish beween wo cases. Fis, Eq. (4) only holds fo one value of zeo bea ae. This implies ha he meanvaiance fonies of he K asses and he K+N asses have only one poin in common (i.e. he inesecion). The iniial mean-vaiance efficien pofolio * w R of he inveso wih zeo bea ae is also efficien fo he exended se of K+N asses. Second, if Eq. (4) holds fo any value of zeo bea ae, 15

19 implying ha he wo mean-vaiance fonies coincide a evey poin (i.e. mean-vaiance spanning). In his case he following esable condiion holds, µ Bµ R = 0 and Bι K ι N = 0 (6) and he iniial mean-vaiance efficien pofolio independen of he isk avesion coefficien. egession: * w R is also efficien on he exended se of K+N asses, The hypohesis ha he genealized Jensen s alpha equals zeo can be esed wih an OLS = α + + ε (7) BR whee α = µ Bµ R and ε is he idiosyncaic eo em ha is geneically uncoelaed wih R and has a covaiance maix εε. In his case, α η) = α ( ι Bι ) η. Noe ha Eq. (7) is essenially a J ( N K mulifaco model. The null hypohesis ha he iniial efficien fonie inesecs wih he exended fonie a he poin of zeo bea ae being can be fomulaed by: H : α ( ι Bι ) η 0 (8) 0 N K = while he null hypohesis ha he iniial fonie spans he exended fonie is: H : α 0 and Bι ι = 0 (9) 0 = K N Boh hypoheses can be esed using a sandad Wald es. A ejecion of he hypoheses implies ha he muual fund oupefoms o undepefoms (in ems of mean-vaiance efficiency) he K benchmak asses. The inuiion of he esicion in Eq. (9) is ha he benchmak asses can fom a pofolio ha has he same expeced eun bu lowe vaiance han he muual funds unde consideaion. Thus if Eq. (9) holds, any mean-vaiance inveso iniially holding he K isky asses canno exend he invesmen oppouniy se by invesing in he N muual funds. Noe ha when boh and R in he egession (7) ae excess euns o euns of zeo-invesmen speads, he condiion ha benchmak asses fom an invesmen pofolio, i.e. Bι ι = 0, is saisfied K N auomaically. In his case, a es of whehe o no he iniial fonie of benchmak asses spans o inesecs he exended fonie by invesing in muual funds is equivalen o a es of whehe α = 0. c. Genealized Shape Raio Anohe fequenly used measue of muual fund pefomance is he Shape aio which is defined as he excess eun of a pofolio (i.e. expeced eun minus he isk fee ae) pe uni of sandad deviaion isk 12 (Shape (1966)). We can easily genealize he Shape aio fo a pofolio wih K benchmak asses: 12 A elaed pefomance measue is he Teyno Raio, defined as a pofolio s excess eun pe uni of is make isk, whee he make isk exposue is measued as he β i of Eq. (12). 16

20 w R R θ K ( η) (10) w ' µ η R ' RR w R As discussed above, when a isk fee asse exiss, he zeo bea ae fo evey inveso can be eplaced by he isk fee ae. Noe ha in a mean - sandad deviaion space, he Shape aio of a meanvaiance efficien pofolio w * is he slope of he angen line a w *. Hence, he mean-vaiance opimizaion of a pofolio is equivalen o maximizaion of he Shape aio. The Shape aio is obained by using he expeced eun and vaiance of a pofolio, while he genealized Jensen s alpha akes ino accoun he covaiance of a pofolio wih an iniial se of asses (Eq. (5)). The Shape aios answe he quesion whehe a pofolio should be pefeed ove anohe pofolio, wheeas Jensen s alpha answes he quesion whehe an inveso who cuenly holds K asses should inves in N new asses. Howeve, hee is a close elaion beween he wo measues: 2 θ N + K K J εε J 2 1 ( η) = θ ( η) + α ( η)' α ( η) (11) 2 whee θ N + K ( η) and θ 2 K ( η) ae he squaed Shape aios of he mean-vaiance efficien pofolios of N+K asses and K asses especively, and whee α J (η ) and εε can boh be obained fom he egession (7). I follows fom Eq. (11) ha Jensen s alpha deemines he poenial impovemen in he maximum aainable Shape aio, i.e. he Shape aio of he mean-vaiance efficien pofolio including he N new asses. Thus a posiive Jensen s alpha also implies benefis fom pofolio divesificaion: by combining he muual funds unde consideaion and he benchmak asses, an inveso can obain a pofolio wih a highe Shape aio han he one ha can be obained by invesing only in benchmak asses. 4.2 Pefomance Evaluaion Mehodologies As discussed in Secion 4.1, muual fund pefomance evaluaion equies an appopiae se of benchmak asses. Asse picing models, fom equilibium models such as he Capial Asse Picing Model (CAPM) o models such as he Abiage Picing Theoy (APT), use diffeen benchmaks of asses. The benchmak asses can be inepeed as faco-mimicking pofolios of isk facos in he economy, such ha a pefomance measue like he genealized Jensen s alpha can be inepeed as a isk-adjused eun. The alpha epesens a fund manage s skill in selecing secuiies based on public and pivae infomaion, o bea a passive faco-mimicking pofolio. a. CAPM The Capial Asse Picing Model is an equilibium model saing ha he make isk is he only non-divesifiable isk faco in capial makes. If he CAPM holds, wo benchmak asses, namely a make pofolio and a isk fee asse, span he mean-vaiance fonie of all asses in he capial make. Alhough he validiy of he CAPM has been quesioned, he Jensen s alpha compued using a single 17

21 make index is sill a popula measue fo muual fund pefomance (e.g. Moningsa epos alphas based on a single make index). In his adiional way of pefomance evaluaion, he following egession is esimaed by an OLS egession: whee α β ( + ε (12) m i, f, = M, i + i f, ) i, i, is he eun on muual fund i ove ime, m is he eun of a boad make index and, is eun on a isk fee deposi. α M, i is he oiginal Jensen s alpha inoduced by Jensen (1968) and is equivalen o he genealized Jensen s alpha (Eq. (5)) wih he zeo bea ae being he isk fee ae. As menioned in Secion 4.1, esing whehe α 0 is equivalen o esing whehe a isk fee deposi and M, i = he make pofolio span he exended efficien fonie including he possibiliy o inves in he muual fund (in his case, he esicion ha pofolio weighs ough o sum o one disappeas as he isk fee asse acs as a benchmak asse). A posiive alpha implies ha an inveso who invess in a isk fee deposi and a make pofolio can exend he invesmen oppouniy se by aking a long posiion in he muual fund, wheeas a negaive alpha suggess ha a sho posiion in he fund yields a highe iskadjused eun. If he CAPM holds, α M, i epesens he skill of a fund manage in selecing mispiced secuiies. Alenaively, α M, i can be inepeed as he excess fund eun adjused fo he make isk, while he muual fund s exposue o he make isk is measued by β i (in Eq. (12)). f b. Mulifaco Models As a single faco of he make isk may no adequaely chaaceize he behavio of expeced equiy euns, Fama and Fench (1993) popose a hee-faco model o capue he coss-secional vaiaion in sock euns, which can also be used o evaluae muual fund pefomance: whee and m smb hml i, f, = α FF, i + β mi ( f, ) + β si + β hi + ε i, smb (13) is he diffeence in euns beween a pofolio of small socks and a pofolio of big socks, hml is he diffeence in euns beween a pofolio of high book-o-make socks and a pofolio of low book-o-make socks. Tesing whehe o no α 0 is equivalen o esing whehe o no he FF, i = mean-vaiance fonie of he exended se of asses coincides wih he fonie of a isk fee deposi, he make pofolio, he spead beween small and big socks, and he spead beween high and low book-omake socks. Noe ha as boh smb and hml ae zeo-invesmen pofolios and a isk fee asse exiss, ( f, m he pofolio consain of he spanning es is saisfied. Alenaively, ), inepeed as hee zeo-invesmen faco mimicking pofolios, such ha adjused fo he hee isk facos. smb and hml can be α FF, i is he fund eun 18

22 Fama and Fench (1996) epo ha hei hee-faco model canno explain he anomaly of he coninuaion of sho-em euns. Caha (1997) exends he Fama-Fench model by adding a momenum faco: whee α β ( β β β + ε (14) m smb hml p1y i, f, = C, i + mi f, ) + si + hi + pi i, p y 1 is he cuen monh s diffeence in euns beween he pevious yea s bes-pefoming and wos-pefoming socks. Fom he mean-vaiance famewok descibed in Secion 4.1, i follows ha an inveso iniially holds a isk fee deposi, a make pofolio, smb and hml, and follows a momenum saegy. Tesing whehe o no α 0 is equivalen o esing whehe he mean-vaiance fonie C, i = coincides wih he iniial fonie afe adding he muual fund. Alenaively, Eq. (14) can be inepeed as a picing model wih fou isk facos, namely he make, size, book-o-make and momenum. c. Condiional Saegies Up o now, we have assumed ha he expeced euns and co-vaiances of muual funds and benchmak asses ae consan ove ime. Howeve, he expeced euns of socks and bonds may be imevaian (Keim and Sambaugh (1986)). Public infomaion on he economic condiion, such as inees aes and sock dividend yields, can pedic he changes in expeced euns ove ime. In he meanvaiance analysis famewok inoduced in Secion 4.1, mean-vaiance opimizing behavio cucially depends on he fis and second momens of euns. When expeced euns change ove ime, so do he opimal pofolio weighs and consequenly he efficien fonie as well. This implies ha an inveso s decision o inves in muual funds depends on changing economic condiions. Feson and Schad (1996) popose a simple mehod o incopoae condiional infomaion in measuing muual fund pefomance. Conside he case of one muual fund and wo benchmak asses, namely a isk fee deposi and a make pofolio. Assume ha he exposue o make isk ( β ) is a linea combinaion of a ime-consan bea ( β i0 ) and a ime-vaying bea ( β i z 1 ): β i, = β i + βi 1z 1, 1 ' i, 0 ' whee z 1is an infomaion se including L vaiables ha eflec he cuen sae of he economy. Boh β i1 and 1 z ae L dimensional ow vecos, and consequenly β i z 1 and β i, ae ime-vaying scalas. Fequenly used infomaion vaiables ae sho-em T-bill aes, dividend yields of a make index, em spead (he diffeence in he yield beween long and sho em bonds), and he copoae bond yield spead (he diffeence in yield beween low and high gade bonds). The condiional one faco model is esimaed via an OLS egession: m m i, f, FS, i βi0( f, ) βi 1( z 1 (' f, )) ε i, 1 ' = α (15) m whee z 1 (' f, ) can be inepeed as he excess eun of invesing z 1unis in he make pofolio a peiod. Compaed o he uncondiional one-faco model of Eq. (12), he condiional one-faco model 19

23 has L+1 facos. I is saighfowad o exend he above condiional model o a condiional K faco model. The model has (L+1)*K facos o esimae, which is a disadvanage of his model induced by a degees-of-feedom poblem. Simila o ohe mulifaco models wih a isk fee asse, a es on he abnomal pefomance of a muual fund is equivalen o esing whehe α 0. A posiive alpha FS, i = indicaes ha an inveso who follows a dynamic saegy o inves in he make pofolio and a isk fee deposi, can exend he invesmen oppouniy se by aking a long posiion in his fund, wheeas a negaive alpha implies a sho posiion. d. Seemingly Unelaed Asses As discussed above, Equaions (12), (13) and (14) can be inepeed as (muli-)faco picing models, in which he benchmak asses ae faco-mimicking pofolios. In his famewok, a common inepeaion of alpha, condiional on he validiy of he picing model, is ha i epesens he skills of a fund manage in selecing secuiies. Howeve, Paso and Sambaugh (2002b) ague ha a non-zeo alpha need no necessaily eflec he fund manages selecion skills if some passive asses can also geneae non-zeo alphas. In ha scenaio, a fund manage could achieve a posiive alpha wihou any selecion skills by invesing in non-benchmak passive asses wih hisoically posiive alphas. To evaluae he fund manages selecion skills, Paso and Sambaugh (2002a,b) popose o exend he Caha (1997) model by adding euns of seemingly unelaed asses (SUAs) o he igh hand side of Eq. (15): whee = α + ( ε (16) m smb hml p1y sua i, f, PS, i β mi f, ) β si β hi β pi βui ' sua is a 4-dimensional ow veco of euns of he following fou SUAs. The fis seemingly unelaed asse is a chaaceisics-mached spead (denoed as CMS) wih a long posiion in low β hi socks (as measued by Eq. (13)) and a sho posiion in high i, β hi socks. The ohe hee seemingly unelaed passive asses (denoed as IP1, IP2, and IP3) ae consuced fom a univese a 20 valueweighed indusy pofolios. The lae hee pofolios mimic he fis hee pincipal componens of he disubances in he muliple egessions of he 20 value-weighed indusy euns on he ohe passive euns: m smb hml f,,,, p1y and cms. The inclusion of he passive asse CMS is moivaed by he empiical evidence ha CMS may be mispiced by he Fama-Fench hee facos (Daniel and Timan (1997)). The euns of he hee indusy pofolios ae expeced o explain he addiional vaiance of funds euns, e.g. when β 0.. ui In his model, an inveso holds a isk fee deposi, a make pofolio, smb and hml. She also follows a momenum saegy, and invess in fou passive asses ha could geneae posiive alphas (i.e. CMS) o explain he fund s vaiance (i.e. IP1, IP2 and IP3). Tesing whehe α 0 is equivalen o PS, i = esing whehe he mean-vaiance fonie afe adding he muual fund coincides wih ha of he iniial 20

24 invesmen oppouniy se. Noe ha Eq. (16) canno be inepeed as a picing model, because he eun on SUAs ahe han on he mimicking pofolios of isk facos. Fuhemoe, i is saighfowad o show ha he alpha in he Caha (1997) model ( α (14)) can also be compued fom he esimaes of Eq. (16): α = + a' (17) C, i α PS, i βui i C, i sua is in Eq. whee α PS, i and βui ae obained fom egession (16), and a i is he inecep in a muliple egession of he fou SUA euns on he ohe passive euns:,, m f, smb hml and p y 1. A non-zeo a i indicaes mispicing of SUA, which would lead o a non-zeo α if β 0. In Eq. (17), he Caha (1997) alpha α C, i is decomposed ino wo elemens: he manage s skills in acive sock selecion ( α PS, i ) and he exposue o he seemingly unelaed passive asses ( β a' ). C, i ui i ui e. Empiical Findings on Muual Fund Pefomance Since he publicaion of Jensen (1968), academics have debaed he issue whehe o no acive pofolio managemen adds value o invesos. The majoiy of sudies conclude ha acively managed muual funds, on aveage, undepefom passively managed pofolios acking make indices. Fo example, Gube (1996) finds ha he aveage muual fund in he US undepefomed he make indices by 65 basis poins pe yea ove he peiod fom 1985 o Fuhemoe, Caha (1997) shows ha fund euns ae negaively coelaed wih fund expense levels and ading aciviies. Using a diffeen appoach, some sudies invesigae he pefomance of he socks held in muual fund pofolios, ahe han he pefomance of muual funds. These sudies (e.g. Ginbla and Timan (1989)) show ha fund manages ha acively ade possess significan sock-picking alen, i.e. fund manages have he abiliy o choose socks ha oupefom hei benchmaks. Wemes (2000) povides a compehensive analysis of pefomance of US muual funds ove he peiod fom 1975 o He finds ha muual funds hold socks ha oupefom he make by 1.3% pe annum, bu he funds ne euns (i.e. afe deducing fees) undepefom by 1% pe annum. Of his 2.3% diffeence in pefomance, 0.7% is due o he undepefomance of non-sock holdings (e.g. cash), 0.8% is due o fund expenses (i.e. managemen fees) and he ohe 0.8% can be explained by ansacion coss. The esuls sugges ha fund manages pick socks well enough o cove hei coss, which suppos he claim ha hee is value in acive pofolio managemen. 4.3 Relaed Pefomance Measues The pevious subsecion pesened vaious models which can evaluae whehe o no a muual fund manage has supeio sock selecion skills o bea a se of passive benchmak asses. In his secion, we 21

25 discuss wo addiional mehodologies used o evaluae muual fund pefomance, namely a es of makeiming abiliy and eun-based syle analysis. a. Make-Timing Asse picing models such as he CAPM pedic ha a pofolio s excess eun is a linea funcion of he excess eun of he make pofolio. Howeve, if a muual fund manage has he abiliy o ime he make, i.e. o incease he fund s exposue o he make pofolio pio o a make incease and o decease he exposue pio o a make decline, he fund s eun will be a non-linea funcion of he make eun. To es fo he make-iming abiliy of a fund manage, Teyno and Mazuy (1966) add a quadaic em o he sandad CAPM egession in Eq. (12): = α (18) m m 2 i, f, i βi ( f, ) γ TM, i ( f, ) ε i, whee γ TM, i measues iming abiliy. If a muual fund manage inceases he fund s make exposue pio o a make incease o educes he make exposue pio o a make decline, he fund s eun will be a convex funcion of he make eun, and γ TM, i will be posiive. egession: Heniksson and Meon (1981) popose o es he make-iming abiliy by employing he following = α + + > + (19) m m m i, f, i βi ( f, ) γ HM, ii{ f, }( f, ) ε i, m m m whee I { > f,} is an indicao vaiable ha equals one if > f, and zeo if f,. In his model, a fund manage decides beween wo levels of make exposue: βi is he fund s make exposue when he excess eun of he make pofolio is negaive, and β + γ i HM, i is he make exposue when he excess make eun is posiive. Consequenly, γ HM, i measues he diffeence in he exposues beween duing he make upun and he downun. A posiive able o ime he make. 13 γ HM, i indicaes ha he fund manage is b. Reun-based Syle Analysis I is widely known ha asse allocaion is impoan in deemining he eun of an inveso s pofolio. Asse allocaion is efeed o as he deeminaion of he pofolio weighs acoss a numbe of 13 Noe ha he non-linea ems in Eq. (18) and (19) ae no euns on benchmak asses o invesmen saegies, and consequenly he alphas in boh ess of iming abiliy do no answe he quesion whehe o no an inveso can exend he mean-vaiance fonie of iniial asses by invesing in he muual fund. A posiive γ HM,i can be inepeed as make-iming abiliy of a muual fund manage. The above wo sudies analyze monhly euns of muual funds and find lile evidence of iming abiliy. Howeve, using daily euns of muual funds, Bollen and Busse (2001) demonsae ha muual funds exhibi significan iming abiliy. γ TM, i o 22

26 asse classes. Examples of such asse classes ae gowh socks, value socks, bonds, seco pofolios o couny pofolios. Alhough muual funds epo hei invesmen objecives (syles), he acual asse allocaion of muual funds does no always coespond o he epoed syle (Bown and Goezmann (1997)). Reun-based syle analysis, inoduced by Shape (1992), is a popula way o esimae muual funds invesmen syles and exposues o majo asse classes. In syle analysis, he following egession is esimaed: = α + + (20) i, i βir ε i, s.. β ' = 1 (20a) i ι K β 0 (20b) i whee i, is he eun of muual fund i in peiod, R is he eun of K asse classes, and ε i, is he idiosyncaic fund eun independen of all K asse classes, implying ha OLS esimaes of α i and βi ae consisen. Regession (20) unde boh he pofolio esicion (Eq. (20a)) and he no sho-selling consain (Eq. (20b)) is efeed o as song syle analysis. α + ε is also known as he acking eo, which i i, measues he diffeence in expeced eun beween he muual fund and he mimicking pofolio. Thus, α i is he aveage acking eo. β i eflecs he elaive pofolio weigh of he mimicking pofolio, a pofolio ha yields he lowes acking eo vaiance. Semi-song syle analysis efes o he case when only a pofolio consain is imposed, and weak syle analysis is efeed o he case wihou consains. In he semi-song syle analysis, De Roon, Nijman and Te Hos (2004) show ha he α i equals he genealized Jensen s alpha (Eq. (5)) of an inveso wih he zeo-bea ae being he expeced eun on he Global Minimum-Vaiance (GMV) pofolio. If one of he benchmak asses is a isk fee deposi, he eun on he GMV pofolio equals he isk-fee ae. In his case, i, and R in Eq. (20) can be eplaced by he euns in excess of he isk-fee ae, and esing whehe α = 0 is equivalen o esing whehe he iniial fonie of K benchmak asses spans he fonie of he exended asses. In he song syle analysis, he inepeaion of alpha is simila o semi-song syle analysis, excep ha he benchmak pofolios become he subse of benchmak asses fo which he posiive consains ae no binding. Noe ha if he acual faco loadings ae posiive, he no sho-selling consain leads o efficiency gains; ohewise imposing he no sho-selling consain may lead o biased esimaes of faco loadings. Moeove, given ha he esimaed syle coefficiens ae uncaed a zeo, he confidence inevals of he esimaed coefficiens should o be adjused as he sandad eos ae no nomally disibued. Noe ha syle analysis uses a mulifaco model o explain fund euns, which only woks well if fund euns ae highly coelaed wih he euns of benchmak asses. Shape (1992) i 23

27 epos ha syle analysis canno explain he euns of unde-divesified pofolios such as seco funds well Pofolio-level Analysis on SRI Mos academic eseach on socially esponsible invesmens focuses on analyzing hei pefomance. Whehe SRI pofolios undepefom o oupefom hei convenional pees is he majo eseach quesion. In his secion, we eview he empiical findings on he pefomance and money-flows of socially esponsible muual funds. 5.1 Reseach Hypoheses and Mehodologies Ehical funds apply vaious sceening pocesses o eain socks complying wih specific social, envionmenal, ehical and copoae govenance cieia. These sceens may have impoan implicaions fo he pefomance of ehical funds. Essenially, hee ae hee hypoheses abou he pefomance of SRI pofolios elaive o non-sri pofolios. The fis wo hypoheses ae abou isk-adjused euns (alphas), while he las hypohesis is abou he isk exposues (beas) of SRI pofolios. The fis hypohesis is ha SRI pofolios undepefom convenional pofolios. SRI sceens impose a consain on he invesmen univese ha is available o non-sri invesos. This consain limis he divesificaion possibiliies and consequenly shifs he mean-vaiance fonie owads less favoable isk-eun adeoffs han hose of convenional pofolios. Hong and Kacpeczyk (2005) neveheless show ha sin socks in he US, i.e. companies involved in poducing alcohol, obacco and gambling, have hisoically oupefomed he sock make by 9.1% pe annum. Divesing fom his undepiced sin pa of he sock make may negaively influence he isk-eun adeoffs of he SRI funds in compaison o convenional funds. Moeove, he SRI sceening pocesses bing abou addiional expenses o fund invesos, which also educe SRI euns. Noe ha his hypohesis implies ha moe singen social sceening will lead o a less favoable financial pefomance. The second hypohesis is ha SRI pofolios oupefom hei convenional pees. As discussed in Secion 3, he empiical eseach shows ha he infomaion on copoae govenance and envionmenal pefomance may be undepiced by he sock makes. Pofolios consuced by means of copoae govenance, envionmenal and social cieia may oupefom hei benchmaks. Theefoe, SRI sceening pocesses geneae value-elevan non-public infomaion ha helps fund manages o selec secuiies and consequenly geneae bee isk-adjused euns (alphas) han convenional muual funds. 14 In he case of hedge funds, hee should be no sho-selling consain (Eq. (20b)). The pofolio consain (Eq. (20a)) can bias he esimaes of syle analysis as hedge funds acually use leveage and sho-selling saegies. In addiion, hedge funds have low coelaions wih majo asse classes. To accoun fo his poblem, Fung and Hsieh (1997) exac five pincipal componens fom hedge fund euns, and consuc five syle facos whose euns ae highly coelaed wih he pincipal componens. 24

28 This is he case whee invesos ae doing (financially) well while doing (socially) good, i.e. invesos ean posiive isk-adjused euns while a he same ime paicipaing in a jus cause. Thee ae wo agumens suppoing his oupefomance hypohesis: fis, sound social and envionmenal pefomance is a posiive signal of good manageial skills, which anslaes ino favoable financial pefomance; second, social and envionmenal sceening educes he possibiliy of incuing high coss duing copoae social cises o envionmenal disases. These agumens imply ha moe singen social sceening may lead o bee financial pefomance. A key assumpion undelying he oupefomance hypohesis is ha convenional pofolio manages do no use he above value-elevan infomaion, which is a odds wih he make efficiency soy. The hid hypohesis is ha SRI pofolios have diffeen isk exposues and heefoe diffeen expeced euns han convenional pofolios. Social and envionmenal facos may be coelaed wih picing isk facos. Fo example, companies wih sound envionmenal pefomance may have a lowe book-o-make aio han companies wih poo envionmenal pefomance (Dowell, Ha and Yeung (2000)). Consequenly, an envionmenally esponsible pofolio may have a lowe isk exposue o he book-o-make faco in he Fama-Fench (1993) picing model han a convenional pofolio. Theefoe he isk exposues and expeced eun of an SRI pofolio may be diffeen fom hose of a convenional pofolio. Noe ha social, envionmenal o ehical sceens may have a diffeen impac on he isk exposues of SRI pofolios. Finally, i should be noed ha he mehodology used o evaluae SRI fund pefomance has evolved. Ealy eseach measues he pefomance of an SRI pofolio using a single index model like he CAPM (Luhe, Maako and Cone (1992), Hamilon, Joe and Saman (1993) and Saue (1997)). In addiion, mos sudies compae he pefomance of SRI funds wih ha of a efeence goup of convenional muual funds. I was common o idenify he efeence goup by a mached-pai analysis: an SRI fund is mached o a convenional muual fund wih simila invesmen objecive and fund size (Mallin e al. (1995), Gegoy e al. (1997), Saman (2000), and Keande e al. (2005)). Recenly, seveal sudies applied mulifaco models, such as he fou-faco model poposed by Fama and Fench (1993) and Caha (1997) o evaluae SRI pefomance. Mulifaco models povide impoan insighs ino he exposue of SRI muual funds o picing isk facos such as size, book-o-make and momenum facos (Baue e al. (2005), and Geczy e al. (2003)). We will discuss he findings of hese papes in he following secions. [Inse Table 4 abou hee] 5.2 Pefomance of SRI Funds in he US a. Risk-Adjused Reuns of SRI funds 25

29 Thee ae seveal sudies evaluaing SRI fund pefomance in he US. Hamilon, Joe and Saman (1993) invesigae he pefomance of 32 SRI funds and 320 andomly seleced non-sri funds in he US fo he peiod of The CAPM-based Jensen s alpha is measued agains he value-weighed NYSE index. Fo he 17 SRI funds wih a longe hisoy, i.e. esablished befoe 1985, he aveage alpha is 0.06% pe monh, which is highe han he aveage monhly alpha ( 0.14%) of he coesponding 170 non-sri funds. Meanwhile fo he 15 SRI funds wih a shoe hisoy, i.e. esablished afe 1985, he aveage alpha is 0.28% pe monh, which is wose han he aveage monhly alpha ( 0.04%) of he 150 non-sri funds. Noe ha he diffeence in aveage alphas beween SRI funds and non-sri funds is no saisically significan. Fo he peiod of , Saman (2000) invesigaes he pefomance of 31 SRI funds in he US. The efeence goup conains 62 non-ehical funds ha have a fund size simila o he ehical funds. The wo goups of funds have simila aveage expense aios: 1.50% fo SRI funds and 1.56% fo non- SRI one. Jensen s alpha is measued agains he S&P 500 Index, while he auho also shows ha choosing he Domini 400 Social Index (DSI 400), he mos well known SRI Index, as a benchmak does no change he esuls. The aveage monhly alpha is 0.42% fo SRI funds and 0.62% fo non-sri funds, while he diffeence beween hem is no significan a he 5% level. The finding suggess ha he pefomance of SRI funds is no significanly diffeen fom ha of non-sri funds, alhough invesing in neihe SRI funds no non-sri funds can exend he mean-vaiance fonie of iniial asses including he make pofolio and a isk-fee deposi. In addiion, he pape also documens ha he DSI 400 index has a highe Shape aio han he S&P 500 index (0.97 vs. 0.92), which indicaes ha a mean-vaiance opimizing inveso should pefe invesing in he fis index. b. Divesificaion Cos of Invesing in SRI Funds Compaing he aveage pefomance of SRI funds o ha of non-sri funds does no necessaily povide useful infomaion o an inveso who can selecively inves in a subse of muual funds. Unlike he above-menioned sudies, Geczy, Sambaugh and Levin (2003) invesigae he divesificaion cos of an inveso who invess in SRI funds bu no in convenional muual funds fo he peiod The auhos consuc opimal pofolios of muual funds fo mean-vaiance invesos wih sho-sale consains. In a Bayesian famewok, each opimizaion uses he pedicive disibuion of fund euns condiional upon a ange of pio beliefs abou model mispicing and manage skills. Then, he opimal pofolio of funds seleced fom 35 SRI funds is compaed o he opimal pofolio seleced fom a univese of 894 non-sri funds. The divesificaion cos of imposing he SRI consain is measued by he diffeence beween he ceainy-equivalen euns (Eq. (2)) on he wo pofolios. This financial cos can be inepeed as a lowe bound on he value of he non-financial uiliy ha an inveso should deive fom socially esponsible invesing. This sudy eveals he significan financial coss of imposing he SRI consain on mean-vaiance opimizing invesos. I also demonsaes ha he SRI cos depends on invesos believes in asse picing 26

30 models and fund manages sock-picking skills. To an inveso who songly believes in he CAPM and ules ou selecion skills, i.e. a make index inveso, he financial cos of he SRI consain is jus 5 basis poins pe monh. To an inveso who sill disallows skill bu insead believes in mulifaco picing models such as he fou-faco model, he cos of he SRI consain is a leas 30 basis poins pe monh. The SRI consain imposes lage coss, moe han 1.5% pe monh, on invesos whose beliefs allow selecion skill, i.e. invesos who ely heavily on individual funds hisoical isk-adjused euns o pedic fuue pefomance. Moeove, fuhe esicing he SRI univese o he funds ha sceen ou sin socks (e.g. alcohol, obacco o gambling) inceases he monhly cos of he SRI consain by an addiional 10 basis poins. In addiion, Geczy e al. (2003) also show ha hee ae impoan diffeences in some basic chaaceisics and he isk exposues beween SRI and non-sri funds. Fo he funds in hei sample, he aveage expense aio of SRI funds is highe han ha of non-sri funds (1.33% vs. 1.10%), wheeas he aveage annual unove of SRI funds is much lowe han ha of non-sri funds (81.5% vs %). The SRI funds have a smalle size han non-sri funds: he aveage asse unde managemen (acoss ime and acoss funds) amouns o $149 million and $257 million, especively. In ode o make hei esuls compaable o ealie eseach, he auhos also compae he pefomance of an equally weighed pofolio of 35 SRI funds o an equally weighed pofolio of 894 non-sri funds. The monhly alpha, measued by he Fama-Fench-Caha model exended wih seemingly unelaed asses (Eq. (16)), of he fis pofolio is highe han ha of he second one (0.21% vs. 0.08%), bu he diffeence is insignifican. This finding is consisen wih he esuls of ohe sudies, namely ha SRI funds pefom no wose han non-sri funds. Meanwhile, he isk exposue of he SRI pofolio o he size faco (SMB faco) is highe han ha of he non-sri pofolio (0.20 vs. 0.16). This implies ha SRI funds ae biased owads small-cap companies. The exposues o he momenum faco and book-o-make faco ae simila fo he wo pofolios. c. Impac of Invesmen Sceens on SRI Fund Pefomance The above-menioned sudies compae he pefomance of SRI funds wih non-sri ones, bu hey do no disinguish beween SRI funds ha use diffeen invesmen sceens. Howeve, as discussed in Secion 5.1, invesmen sceens may affec he isk-exposues and isk-adjused euns of SRI funds. In he academic lieaue, few aemps have been made o invesigae he impac of invesmen sceens on SRI fund pefomance. Goldeye, Ahmed and Dilz (1999) sudy he pefomance of 49 SRI funds fo he peiod of , which include 29 equiy funds, 9 bond funds and 11 balanced funds. The aveage Jensen s alpha of he 29 SRI equiy funds is 0.49% pe annum, wheeas ha of 20 non-sri equiy funds is 2.78%. The diffeence beween he wo aveage alphas is no significan, which indicaes he pefomance of hese wo goups of funds is no dissimila. The mos ineesing finding of his pape is ha he SRI funds using posiive sceens oupefom SRI funds ha do no employ posiive sceens. The aveage monhly alpha fo equiy SRI funds wih and wihou posiive sceens is 0.11% and 0.81%, especively. The diffeence is saisically significan wih a -saisic of This finding, alhough i is 27

31 based on a small sample of 29 funds, suppos he hypohesis ha invesmen sceens affec he pefomance of SRI funds. A ecen sudy by Bane and Salomon (2006) examines whehe o no moe singen social sceens lead o bee financial euns of 67 SRI funds. The auhos documen a non-linea elaionship beween fund pefomance and invesmen sceens. When he numbe of social sceens (boh posiive and negaive ones) inceases, he fund s annual eun declines a fis, bu hen ebounds as he numbe of sceens eaches a maximum. Noe ha his pape examines expeced euns ahe han isk-adjused euns. Given ha he expeced eun consiss of boh isk-adjused euns and loadings on isk pemium, i would be ineesing o see how invesmen sceens influence each of hese wo componens sepaaely. 5.3 Pefomance of SRI Funds in he UK A few sudies invesigae he pefomance of ehical funds in he UK. Luhe, Maako and Cone (1992) sudy 15 ehical funds in he UK fo he peiod. Jensen s alphas of he ehical funds have a mean of 0.03% pe monh, which is no significanly diffeen fom zeo. This implies ha ehical funds have a simila pefomance as he benchmak asses. The auhos also documen ha he ehical funds have elaively high pofolio weighs on small-cap companies. To conol fo he poenial smallcap bias of ehical funds, Luhe and Maako (1994) measue he Jensen s alphas of 9 ehical funds in wo ways, eihe agains he FT All Shae Index o agains a Small-Cap Index. The auhos find ha he R-squaed is highe in he fis egession han he second one, which suppos he hypohesis ha he SRI pofolio is biased owads small-caps. Sill, he aveage alphas measued in boh hese ways ae no significanly diffeen fom zeo. Unlike he above-menioned UK sudies, Mallin, Saadouni and Bison (1995) compae he Jensen s alphas of 29 ehical funds o hose of 29 non-ehical funds wih a simila fund size and age. The monhly alphas of ehical funds ange fom -0.28% o 1.21%, while 22 ou of he 29 alphas ae posiive. The alphas of non-ehical funds, 23 of which ae posiive, ange fom -0.41% o 1.56% pe monh. Thee is lile evidence ha he wo goups of funds have diffeen isk-adjused euns. Gegoy, Maako and Luhe (1997) examine 18 ehical funds ou of he above 29 funds fo he peiod. The efeence goup conains 18 non-ehical funds ha have simila fund size, age, and invesmen aea o he ehical funds. To accoun fo he small-cap bias, Jensen s alphas ae calculaed based on wo facos, namely he FT All Shaes Index and he Hoae Gove Small Cap Index. The wo-faco model has a highe adjused R-squaed han he single-faco model, and ha mos of he ehical funds have a significan exposue o he small-cap faco. The alphas of ehical funds ange fom 0.71% o 0.24% pe monh, bu almos none ae saisically significan. Moeove, in a egession wih boh ehical and nonehical funds, he indicao vaiable of ehical funds does no have significan impac on fund pefomance 28

32 afe conolling fo fund age, size, and he make isk. This implies ha he diffeence in pefomance beween an SRI fund and a non-sri fund is again no saisically significan. 5.4 Pefomance of Inenaional SRI Funds Thee ae seveal ecen sudies invesigaing he pefomance of SRI funds in counies ohe han he US and UK. Fo he sho peiod of , Keande, Gay, Powe and Sinclai (2005) sudy he pefomance of 40 SRI funds in Euope using weekly daa. The counies coveed in he sample include Belgium (1 fund), Gemany (4 funds), Nehelands (2 funds), Noway (2 funds), Sweden (11 funds), Swiss (2 funds) and he UK (18 funds). The efeence goup o he SRI funds consiss of 40 non-sri funds ha ae fom he same counies and have simila fund size, age, and invesmen univese as he SRI funds. The aveage Jensen s alpha of SRI funds and non-sri ones is simila (0.20% vs. 0.12% pe monh), and he diffeence is saisically insignifican. This finding is consisen wih he esuls of pevious sudies showing ha he pefomance of SRI funds and non-sri funds ae vey simila. In addiion, he auhos es he make iming abiliy of SRI and non-sri fund manages, using he Heniksson and Meon (1981) model (Eq. (19)). The iming coefficiens ae also simila fo he wo ypes of funds (-0.29 vs. 0.28), and each of hem is significan a he 0.05 level. Howeve, he signs of he iming coefficiens ae negaive, which seems o signify ha boh SRI and non-sri fund manages ime he make in he wong diecion. [Inse Table 5 abou hee] Baue, Koedijk and Oen (2005) compae he pefomance of 103 SRI funds wih 4,384 non-sri funds ove he peiod The SRI funds come fom Gemany (16 funds), he UK (32 funds) and he US (55 funds). The sample is suvivoship fee, as i includes dead funds (all of which ae non-sri funds). Ignoing dead funds would oveesimae he aveage euns of he non-sri funds in by 0.01%, 0.02%, 0.03% pe monh fo he hee counies, especively. Fund pefomance is measued by he fou faco model (Eq. (14)). As documened in pevious sudies, ehical funds have a smalle size and chage highe managemen fees han convenional funds. The aveage monhly alphas of SRI funds ae 0.29%, 0.09% and 0.05% fo Geman, UK domesic and US domesic funds, especively. The US domesic ehical funds significanly undepefom convenional domesic funds, while he diffeence beween he US inenaional ehical funds and he US inenaional convenional funds is insignifican. The UK ehical funds, boh domesic and inenaional funds, significanly oupefom convenional funds. The diffeence in aveage alphas beween Geman SRI and non-sri funds is insignifican. The auhos conclude ha hee is lile evidence ha SRI funds significanly ove- o undepefom non-sri funds. In addiion, Baue e al. (2005) also documen ha Geman and US ehical funds passed hough a leaning phase: afe significan undepefomance in he beginning of he 1990s, hey mached convenional fund pefomance ove he peiod. Olde ehical funds (launched befoe he end 29

33 of 1997) oupefom younge ehical funds (launched since 1998). Meanwhile, SRI funds have diffeen isk exposues han non-sri funds. Geman and UK ehical funds ypically inves moe in small-cap socks han US ones. All SRI funds ae moe gowh- han value-oiened. Anohe ineesing finding is ha while he olde ehical funds clealy deviaed fom convenional funds wih espec o he exposues o make isk, size and book-o-make facos, younge funds follow less ponounced invesmen syles. Anohe pefomance sudy of inenaional SRI funds is pefomed by Schode (2004). His sample includes 30 US funds and 16 Geman and Swiss funds. A wo-faco model is employed wih boh a bluechip index and a small-cap index as benchmaks o esimae he alphas. The monhly alphas ange fom 2.06% o 0.87%. Thiy-eigh ou of he 46 alphas ae negaive, bu only 4 ae significan a he 5% level. This suggess ha SRI funds do no significanly undepefom he benchmak pofolio consising of boh lage socks and small socks. Using he song-fom syle analysis inoduced in Secion 4.3 (Eq. (20)), Schode (2004) also sudies he exposues of SRI funds o he small-cap index and a numbe of indusy indices. Fo a pofolio minimizing he acking-eo isk, he aveage exposues o he small-cap index ae 42% fo Geman and Swiss SRI funds and 32% fo he US funds. This finding confims he small-cap bias fo SRI funds, especially fo he Geman and Swiss funds. Moe ineesingly, he aveage exposue o non-cyclical sevice and consume goods (such as food, beveage, healhcae and elecom) indusies is elaively high fo all SRI funds. In addiion, Geman and Swiss funds also have high exposues o uiliies (such as eleciciy, gas and wae), wheeas he US funds have high exposues o he financial and IT secos. Some of Schode s esuls ae consisen wih hose of Baue e al. (2005): he Euopean SRI funds ae biased owads small socks, while he US ones ae biased owads lage fims. The pape also ess he make iming abiliy of SRI fund manages by a condiional vesion of he Teyno and Mazuy (1966) model (Eq. (18)). The significance level of he iming coefficiens suggess ha only 5 ou of he 46 funds demonsae posiive iming abiliy, while 7 fund manages ime he make in he wong diecion (6 of whom ae Geman and Swiss fund manages). Thee ae wo sudies invesigaing he pefomance of SRI funds ouside he US and Euope. Boh sudies measue he isk-adjused euns by he condiional vesion of Caha (1997) model. Baue, Oen and Touani Rad (2006) find ha, fo he peiod of , Ausalian domesic ehical funds undepefom hei domesic convenional counepas by 1.56% pe yea, while he Ausalian inenaional ehical funds oupefom hei convenional pees by 3.31% pe yea. Howeve, none of hese diffeences ae saisically significan. Fo Canadian SRI funds, Baue, Dewall and Oen (2006) show ha he diffeence in aveage alphas is insignifican beween he 8 SRI funds and 267 non-sri funds (-0.21% vs. 0.18% pe monh). Hence, hei findings show ha SRI funds do no ou- o undepefom hei convenional counepas in Ausalia and Canada. Using a daabase consising of 463 SRI muual funds in he US, UK, Coninenal Euope and Asia- Pacific, Renneboog, Te Hos and Zhang (2007) sudy he isk and eun chaaceisics of SRI muual funds aound he wold. They hypohesize ha invesos may be willing o pay a pemium fo fims 30

34 meeing ehical/social sandads. Consequenly, such fims may be piced above hei fundamenal value, which esuls in undepefomance by SRI funds. The auhos also povide evidence in suppo of his hypohesis: SRI funds in many Euopean and Asia-Pacific counies songly undepefom domesic benchmak pofolios. Fo insance, he isk-adjused euns of he aveage SRI funds in Belgium, Fance, Ieland, Japan, Noway, Singapoe, and Sweden ae on aveage less han 5% pe annum. In addiion, passive pofolios of ehical fims in Euope, i.e. companies included in he Euopean ehical indices, significanly undepefom he fou benchmak facos by abou 4.5% pe annum. While he isk-adjused euns of SRI funds in he UK and US ae no saisically diffeen fom hose of non-sri funds, he holdings of hese SRI funds may be vey simila o hose of convenional funds as 97% of he eun vaiaions of he UK and US SRI funds can be eplicaed by pofolios mimicking he fou isk facos. Meanwhile, he esuls show ha invesos ae willing o pay a pemium fo ehical fims fo wo easons. Fis, hey pay fo he isk educion by he ehical sceening of fims. Second and moe impoanly, he behavioal bias of avesion o unehical copoae behavio plays a ole, as he pemium paid is much highe han wha is equied o compensae isk. Fuhemoe, Renneboog e al. (2007) find ha he oal wealh invesed in ehical funds in Euope (excluding he UK) and he Res of Wold is educed by abou 6% pe annum on a isk-adjused basis. Pa of ehical invesos wealh is ansfeed o he fund manages who chage managemen fees of abou 1.5% pe annum. On he exisence of a sma money effec in he SRI fund indusy, he esuls ae mixed: alhough ehical invesos ae unable o idenify he funds ha will oupefom hei benchmaks ex ane, hee is some fund-selecion abiliy in idenifying ehical funds ha will pefom pooly. In addiion, he SRI consains on he invesmen univese have a minimal impac on isk divesificaion, and hee is lile evidence of make iming abiliy by SRI fund manages aound he wold. Alhough SRI pofolios have a lowe Shape aio and ae less (mean-vaiance) efficien han convenional pofolios, SRI funds now hold a moe divesified ange of asses in hei pofolios and gadually convege owads convenional funds. Moeove, he sceening aciviies of SRI funds affec funds expeced euns: funds wih moe SRI sceens have bee euns even afe conolling fo well-known eun pedicos. An ineesing esul is ha employing an in-house eseach eam on SRI issues inceases fund euns by 1.2% pe annum, which suppos he hypohesis ha he sceening pocess geneaes value-elevan non-public infomaion. I also appeas ha he SRI sceens have significan impac on funds isk faco loadings Thee is also anohe line of eseach ha invesigaes he pefomance of SRI pofolios by consucing pofolios using fim-level infomaion. Fo insance, Gossman and Shape (1986) compae he euns of a value-weighed Souh Afica-fee pofolio o hose of a compaable unsceened pofolio, and find ha he diffeence in euns beween hese wo pofolios is insignifican. Using KLD social daa a he fim level, Guead (1997) and Sone, Guead, Gulekin, and Adams (2001) documen ha hee ae no saisically significan diffeences in euns beween SRI sceened pofolios and unsceened pofolios. Given ha we focus on he pefomance of ehical muual funds, we do no discuss hese sudies in deail. 31

35 To conclude, in his subsecion we pesen empiical evidence of he pefomance of SRI muual funds. Fo SRI funds in he US and UK, hee is lile evidence ha he isk-adjused euns of SRI funds ae diffeen fom hose of convenional funds. Howeve, SRI funds in Coninenal Euope and Asia- Pacific songly undepefom benchmak pofolios. Fuhemoe, SRI funds have specific ils in indusy composiions and isk exposues. 5.5 Money-Flows of Inenaional SRI Funds As descibed in he Secions 5.2 o 5.4, mos of he exising empiical sudies on SRI funds focus on SRI fund pefomance. In spie of he fac ha hese SRI funds expeienced a emendous gowh in mos developed economies aound he wold, lile is known abou how invesos selec funds wih explici non-financial aibues. Invesos in SRI funds may cae moe abou social o ehical issues in hei invesmen decisions han abou fund pefomance. Some ecen sudies on he behavio of invesos in convenional muual funds show ha boh financial and non-financial fund aibues affec he choice of a paicula muual fund. Risk-adjused as well as aw pas pefomance significanly affec he money-flows of muual funds (Chevalie and Ellison, 1997; Goezmann and Peles, 1997; Sii and Tufano, 1998; Goiaev, Nijman and Weke, 2005). While he op pefoming muual funds aac mos of he inflows, he weakly pefoming funds ae hadly affeced by ouflows. This indicaes ha once money is invesed, i ends o be ahe sicky (Gube, 1996). Fuhemoe, non-financial aibues, like muual fund visibiliy (Sii and Tufano, 1998) and muual fund adveising (Jain and Wu, 1999), have a significan impac on he money-flows o muual funds. Bek and Geen (2004) inoduce a Bayesian model o explain why invesos chase pas pefomance. Accoding o his model, aional invesos use pas pefomance o updae hei infomaion on manageial abiliy, which explains he song money-flows o he bes pefoming funds. The fis sudy on he deeminans of money-flows in he SRI fund indusy was conduced by Bollen (2006), which concenaed on a univaiae analysis of money-flows and pas euns fo US SRI funds. This sudy shows ha, in he US, he volailiy of money-flows is lowe in SRI funds han in non- SRI funds. Fuhemoe, he money-flows of SRI funds ae less sensiive o lagged negaive euns han flows in convenional funds, bu moe sensiive o lagged posiive euns. Using a daabase consising of 410 SRI muual funds aound he wold, Renneboog, Te Hos, and Zhang (2006) sudy he money-flows ino and ou of he SRI fund indusy. They find ha SRI invesos chase pas euns, pas eun ankings, and pesisence in pas pefomance, as do invesos in convenional muual funds. In paicula, SRI funds ha can be denoed as pesisen winnes eceive abou 30% moe money inflows han pesisen loses. Unless a fund pesisenly undepefoms, SRI invesos cae moe abou pas posiive euns han abou pas negaive euns. They also show ha a highe sceening inensiy aacs moe money-inflows han funds employing few sceens. An ineesing diffeence beween SRI funds and convenional funds is he effec of fund fees on he money-flows. The 32

36 decision o inves in an SRI fund is less affeced by managemen fees and load fees han he decision o inves in convenional funds. This may incenivize fund managemen companies o ene he SRI make as ehical invesos seem o be willing o pay fo he managemen of pofolios consisen wih hei social objecives. The vaiabiliy in he money-flows is a seious concen of muual fund manages because i can depess fund pefomance due o he coss of ading he shaes of he funds pofolios which ae iggeed by he ne puchases o sales of shaes in he funds. Renneboog e al. (2006) find ha smalle, younge o iskie SRI funds have highe money-flow volailiy, paly esuling fom he highe makeing effos of hese funds. Fuhemoe, he money-flow volailiy is highe fo SRI funds ha expeienced good ecen pefomance, belong o a lage fund family o o a family wih op pefoming funds. This may be due o he fac ha myopic invesos pefe funds belonging o a lage family because swiching beween funds wihin he family can usually be done a low cos. An ineesing esul is ha shaeholde acivism and in-house eseach of an SRI fund significanly lowes he monhly flow volailiy by 1.4% and 0.6%, especively. Appaenly, hese wo aibues aac moe sable invesos o he fund. The auhos also examine whehe o no SRI invesos ae able o selec (inves hei money in) funds ha will geneae high fuue pefomance. The esuls show ha he SRI funds aacing mos flows ae no geneaing highe euns. This finding is einfoced by he analysis of he impac of pas flows on pesisence in (fuue) euns: hey demonsae ha he pobabiliy ha funds aise as pesisen winnes is educed when hese funds aac lage pas money inflows. They inepe his evidence by he emegence of deceasing euns of scale in fund invesmens. Thus, i seems ha ehical money is no financially sma in he sense ha he muual fund eallocaion decisions of SRI invesos educe hei wealh. Bu hee is one cavea o his conclusion: hey find a posiive elaion beween he use of SRI sceens and fuue pefomance: he sceening inensiy of SRI funds impoves euns. In paicula, an SRI fund wih 8 moe sceens is expeced (all else equal) o have a highe abnomal eun of 38 basis poins pe monh (i.e. 4.6% annually) han SRI funds employing few sceens. Appaenly, funds wih moe SRI sceens aacing highe money-inflows have bee fuue euns han funds focusing on one o a few invesmen sceens. 6. Conclusion This pape suveys he lieaue on socially esponsible invesmens (SRI). Ove he pas decade, SRI has expeienced an explosive gowh aound he wold, and naional govenmens in many wesen counies have aken egulaoy iniiaives egading SRI. Paicula o he SRI funds is ha boh financial goals and social objecives ae pusued. The lieaue on copoae social esponsibiliy (CSR) shows ha, in geneal, good copoae govenance, sound envionmenal sandads, and good managemen owads sakeholde elaions can 33

37 ceae value fo shaeholdes. Paicipaing in ohe social and ehical issues is likely o desoy shaeholde value. Mos exising eseach on SRI fund pefomance finds lile evidence ha he isk-adjused euns of SRI funds in he US and UK ae diffeen fom hose of convenional funds. Howeve, hee is some evidence ha SRI funds in coninenal Euope and Asia-Pacific songly undepefom benchmak pofolios. Finally, he sudies on he money-flows of SRI funds show ha he volailiy and money-flows is lowe in SRI funds han in convenional funds, and ha SRI inveso s decision o inves in an SRI fund is less affeced by managemen fees and funds isk han convenional fund invesos. 34

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39 Goiaev, A. T. Nijman and B. Weke, 2005, Pefomance infomaion disseminaion in he muual fund indusy, Woking Pape Tilbug Univesiy. Gegoy, A., J. Maako, and R. Luhe, 1997, Ehical uni us financial pefomance: small company effecs and fund size effecs, Jounal of Business Finance and Accouning 24, Ginbla, M. and S. Timan, 1989, Muual fund pefomance: an analysis of quaely pofolio holdings, Jounal of Business 62, Gossman, B.R. and W.F. Shape, 1986, Financial Implicaions of Souh Afican Divesmen, Financial Analyss Jounal 42 (4), Gube, M., 1996, Anohe puzzle: he gowh in acively managed muual funds, Jounal of Finance 51, Guead, J.B., 1997, Addiional evidence on he cos of being socially esponsible in invesing, Jounal of Invesing 6(4), Hamilon, S., H. Jo and M. Saman, 1993, Doing well while doing good? The invesmen pefomance of socially esponsible muual funds, Financial Analyss Jounal 49 (6), Heinkel, R., A. Kaus, and J. Zechne, 2001, The effec of geen invesmen on copoae behavio, Jounal of Financial and Quaniaive Analysis 35, Heniksson, R. and R. Meon, 1981, On make iming and invesmen pefomance II saisical pocedues fo evaluaing foecasing skills, Jounal of Business 54(4), Hillman, A. and G. Keim, 2001, Shaeholde value, sakeholde managemen, and social issues: wha s he boom line? Saegic Managemen Jounal 22, Hong, H. and M. Kacpeczyk, 2005, The pice of sin: he effec of social noms of makes, Woking Pape Pinceon Univesiy. Jain, P. and J. Wu, 2000, Tuh in muual fund adveising: evidence on fuue pefomance and fund flows, Jounal of Finance 55 (2), Jensen, M., 1968, The pefomance of muual funds in he peiod , Jounal of Finance 23, Jensen, M., 2001, Value Maximizaion, Sakeholde heoy, and he copoae objecive funcion, Jounal of Applied Copoae Finance 14 (3). Jensen, M., 2004, Agency coss of ovevalued equiy and he cuen sae of copoae finance, Euopean Financial Managemen 10(4), Keim, D.B. and R.F. Sambaugh, 1986, Pedicing euns in he bond and sock makes, Jounal of Financial Economics 17, Klassen, R., and C. McLaughlin, 1996, The impac of envionmenal managemen on fim pefomance, Managemen Science 42 (8), Kona, S. and M. Cohen, 2001, Does he make value envionmenal pefomance? Review of Economics and Saisics 83(2), Keande, N., G. Gay, D.M. Powe and C.D. Sinclai, 2005, Evaluaing he pefomance of Ehical and Non-SRI funds: a mached pai analysis, Jounal of Business, Finance and Accouning 32(7), Lewison, M., 1999, Conflics of ineess? The ehics of usuy, Jounal of Business Ehics 22 (4), Luhe, R., and J. Maako, 1994, The pefomance of ehical uni uss: choosing an appopiae benchmak, Biish Accouning Review 26, Luhe, R., J. Maako and D. Cone, 1992, The invesmen pefomance of UK ehical uni uss, Accouning, Audiing & Accounabiliy Jounal Review 5, Mallin,C.A., B. Saadouni and R.J. Bison, 1995, The financial pefomance of ehical invesmen funds, Jounal of Business Finance & Accouning 22 (4), Paso, L. and R.F. Sambaugh, 2002a, Muual fund pefomance and seemingly unelaed asses, Jounal of Financial Economics 63, Paso, L. and R.F. Sambaugh, 2002b, Invesing in equiy muual funds, Jounal of Financial Economics 63, Renneboog, L., J. Te Hos, and C. Zhang, 2006, Is ehical money financially sma? Woking Pape Tilbug Univesiy and Euopean Copoae Govenance Insiue. Renneboog, L., J. Te Hos, and C. Zhang, 2007, The pice of ehics: Evidence fom socially esponsible muual funds aound he wold, Woking Pape Tilbug Univesiy. Schode, M., 2004, The pefomance of socially esponsible invesmens: invesmen funds and indices, Financial Makes and Pofolio Managemen 18(2), Shape, W., 1966, Muual fund pefomance, Jounal of Business, 39(1), Shape, W., 1992, Asse allocaion: managemen syle and pefomance measuemen, Jounal of Pofolio Managemen, 18,

40 Social Invesmen Foum (SIF), 2001, 2003, Repo on esponsible invesing ends in he US, hp:// Social Invesmen Oganizaion (SIO), 2002, Canadian social invesmen eview, hp:// Spakes, R., 2002, Socially Responsible invesmen: a global evoluion, John Wiley & Sons, London. Saman, M., 2000, Socially esponsible muual funds, Financial Analyss Jounal 56 (3), Sone, B.K., J.B. Guead, M.N. Gulekin and G. Adams, 2001, Socially esponsible invesing: Song evidence of no significan cos fo acively managed pofolios, Bigham Young Univesiy Woking Pape. Susainable Invesmen Reseach Inenaional (SiRi), 2003, Geen, social and ehical funds in Euope, available a hp:// Te Hos, J., 1998, Longiudinal analysis of muual fund pefomance, CenER Disseaion Seies No.44, Tilbug Univesiy. Tiole, J., 2001, Copoae govenance, Economeica 69, Teyno, J. and K. Mazuy, 1966, Can muual funds ouguess he make? Havad Business Review 44, UK Social Invesmen Foum (UKSIF), 2001, Repo on SRI in he UK, hp:// Wemes, R., 2000, Muual fund pefomance: an empiical decomposiion ino sock-picking alen, syle, ansacion coss and expenses, Jounal of Finance, 55(4),

41 Table 1: Asse unde managemen of SRI funds and pofolios Panel A of his able pesens he numbe (N) of eail SRI muual funds and hei asses unde managemen (AUM, in billion US$), and Panel B epos he AUM of SRI sceened pofolios (including he SRI AUM by pension funds and insuance companies). In Panel A, he Euopean counies included ae: Ausia, Belgium, Finland, Fance, Gemany, Ieland, Ialy, Noway, Poland, Spain, Sweden, Swizeland, The Nehelands, and he UK, wheeas in Panel B due o daa availabiliy, Belgium, Finland, Ieland, Noway, Poland and Sweden ae no included. Daa in his able ae colleced fom he following souces: US: SIF (1995, 1997, 1999, 2001, 2003, 2005); Euope: SiRi (2002, 2003, 2005), Euosif (2003); Canada: SIO (2002, 2004); Ausalia: EIA (2001, 2002, 2003, 2005). US Euope Canada Ausalia Yea N AUM ($b) N AUM ($b) N AUM ($b) N AUM ($b) Panel A: SRI eail muual funds Panel B: SRI eail and insiuional fund pofolios

42 Table 2: SRI egulaions This able summaizes he egulaoy iniiaives egading SRI aken by naional govenmen in wesen counies. Couny Ausalia Belgium Fance Gemany Ialy Nehelands Sweden UK US SRI elaed egulaions In a 2001 bill i is saed ha all invesmen fims poduc disclosue saemens should include a descipion of he exen o which labo sandads o envionmenal, social o ehical consideaions ae aken ino accoun. Since 2001, all lised companies on he Ausalian Sock Exchange ae equied o make an annual social esponsibiliy epo. In 2001, Belgium passed he Vandeboucke law, which equies pension funds o epo he degee o which hei invesmens ake ino accoun social, ehical and envionmenal aspecs. In May 2001, he legislaion New Economic Regulaions came ino foce equiing lised companies o publish social and envionmenal infomaion in hei annual epos. Since Febuay 2001 manages of he Employee Savings Plans ae equied o conside social, envionmenal o ehical consideaions when buying and selling shaes. Since 1991, he Renewable Enegy Ac gives a ax advanage o closed-end funds o inves in wind enegy. Since Januay 2002, ceified pivae pension schemes and occupaional pension schemes mus infom he membes in wiing, whehe and in wha fom ehical, social, o ecological aspecs ae aken ino consideaion when invesing he paid-in conibuions. Since Sepembe 2004 pension funds ae equied o disclose non-financial facos (including social, envionmenal and ehical facos) influencing hei invesmen decisions. In 1995, he Duch Tax Office inoduced a Geen Savings and Invesmen Plan, which applies a ax deducion fo geen invesmens, such as wind and sola enegy, and oganic faming. Since Januay 2002, Swedish naional pension funds ae obliged o incopoae envionmenal and ehical aspecs in hei invesmen policies. In July 2000, he Amendmen o 1995 Pensions Ac came ino foce, equiing usees of occupaional pension funds in he UK o disclose in he Saemen of Invesmen Pinciples he exen (if a all) o which social, envionmenal and ehical consideaions ae aken ino accoun in he selecion, eenion and ealizaion of invesmens. The Tusee Ac 2000 came ino foce in Febuay Chaiy usees mus ensue ha invesmens ae suiable o a chaiy s saed aims, including applying ehical consideaions o invesmens. In 2002, The Cabine Office in he UK published he Review of Chaiy Law in 2002, which poposed ha all chaiies wih an annual income of ove 1 m should epo on he exen o which SEE issues ae aken ino accoun in hei invesmen policy. The Home Office acceped heses ecommendaions in The Associaion of Biish Insues (ABI) published a disclosue guideline in 2001, asking lised companies o epo on maeial SEE isks elevan o hei business aciviies. Secion 406 of he Sabanes-Oxley Ac, which came ino effec in July 2002, equies companies o disclose a wien code of ehics adoped by hei CEO, chief financial office and chief accounan. 39

43 Table 3: SRI sceens This able summaizes he invesmen sceens used by SRI muual funds. In he las column, he - efes o a negaive sceen, wheeas + efes o a posiive one. Daa ae compiled fom Social Invesmen Foum (2003: 42) and he Naual Capial Insiue ( Sceens Definiions Type Tobacco Avoid manufacues of obacco poducs - Alcohol Avoid fims ha poduce, make, o ohewise pomoe he consumpion of - alcoholic beveages Gambling Avoid casinos and supplies of gambling equipmen - Defense /Weapons Avoid fims poducing weapons fo domesic o foeign miliaies, o fieams fo - pesonal use Nuclea Powe Avoid manufacues of nuclea eacos o elaed equipmen and companies ha - opeae nuclea powe plans Iesponsible Foeign Opeaions Avoid fims wih invesmens in govenmen-conolled o pivae fims locaed in oppessive egimes such as Buma o China, o fims which misea he indigenous peoples of developing counies - Ponogaphy / Adul Eneainmen Aboion /Bih Conol Labo Relaions and Wokplace Condiions Envionmen Copoae Govenance Business Pacice Employmen Divesiy Human Righs Animal Tesing Avoid publishes of ponogaphic magazines; poducion sudios ha poduce offensive video and audio apes; companies ha ae majo sponsos of gaphic sex and violence on elevision Avoid povides of aboion; manufacues of aboion dugs and bih conol poducs; insuance companies ha pay fo elecive aboions (whee no mandaed by law); companies ha povide financial suppo o Planned Paenhood Seek fims wih song union elaionships, employee empowemen, and/o employee pofi shaing. Avoid fims exploiing hei wokfoce and sweashops Seek fims wih poacive involvemen in ecycling, wase educion, and envionmenal cleanup Avoid fims poducing oxic poducs, and conibuing o global waming Seek companies demonsaing "bes pacices" elaed o boad independence and elecions, audio independence, execuive compensaion, expensing of opions, voing ighs and/o ohe govenance issues. Avoid fims wih anius violaions, consume faud, and makeing scandals. Seek companies commied o susainabiliy hough invesmens in R&D, qualiy assuance, poduc safey Seek fims pusuing an acive policy elaed o he employmen of minoiies, women, gays/lesbians, and/o disabled pesons who ough o be epesened amongs senio managemen Seek fims pomoing human ighs sandads Avoid fims which ae complici in human ighs violaions Seek fims pomoing he especful eamen of animals Avoid fims wih animal esing and fims poducing huning/apping equipmen o using animals in end poducs Renewable Enegy Seek fims poducing powe deived fom enewable enegy souces + Bioechnology Seek fims ha suppo susainable agiculue, biodivesiy, local fames, and indusial applicaions of bioechnology. Avoid fims involved in he pomoion o developmen of geneic engineeing fo agiculual applicaions. + - Communiy Involvemen Seek fims wih poacive invesmens in he local communiy by sponsoing chaiable donaions, employee voluneeism, and/o housing and educaional pogams Shaeholde The SRI funds ha aemp o influence company acions hough diec dialogue + acivism wih managemen and/o voing a Annual Geneal Meeings Non-maied Avoid insuance companies ha give coveage o non-maied couples

44 Healhcae/ Phamaceuicals Inees-based Financial Insiuions Pok Poduces Avoid healhcae indusies (used by funds ageing he Chisian Scienis eligious goup) Avoid financial insiuions ha deive a significan poion of hei income fom inees eanings (on loans o fixed income secuiies). (Used by funds managed accoding o Islamic pinciples) Avoid companies ha deive a significan poion of hei income fom he manufacuing o makeing of pok poducs. (Used by funds managed accoding o Islamic pinciples)

45 Table 4: Reseach mehodologies of SRI sudies This able summaizes he eseach mehodologies of sudies on socially esponsible muual funds. Sudy Couny Peiod No. of Funds Luhe, Maako and Cone (1992) Luhe and Maako (1994) Pefomance Make Indices Measues UK CAPM FT All Shae Index o MSCI Wold Index UK CAPM FT All Shae Index o a Small Cap Index Refeence Goup (non-sri funds) No compaisons wih non-sri funds. No compaisons wih non-sri funds. Hamilon, Joe and Saman (1993) US CAPM Value-weighed NYSE Index 320 non-sri funds, andomly seleced Mallin, Saadouni & Bison (1995) Gegoy, Maako and Luhe (1997) UK CAPM FT All Shaes Index 29 non-sri funds, mached by fund size and age UK A wo-faco model wih wo indices FT All Shaes Index and Hoae Gove Small Cap index 18 non-sri funds, mached by fund size, age, invesing aea and fund ype. Goldeye, Ahmed and Dilz (1999) US CAPM Wilshie 5000 Equiy Index (fo equiy funds) 180 non-sri funds, mached by invesmen objecive, fund size and make bea. Saman (2000) US CAPM S&P 500 o DSI 400 Index 62 non-sri funds, mached by fund size. Geczy, Sambaugh and Levin (2003) US CAPM Fama-Fench (1992) CRSP NYSE/ AMEX/ NASQAQ Index 894 non-sri funds, including dead funds Caha (1997) Paso and Sambaugh (2002): IP1-4 Schode (2004) US, Gemany Swizeland A wo-faco model wih wo indices Timing: Teyno and Mazuy (1966) Condiional: Feson and Schad (1996) MSCI Wold Index and Salomon Smih Baney Wold Index (fo inenaional funds) S&P 500 and Wilshie Small Cap 250 Index (fo domesic US funds) No compaisons wih non-sri funds. (Song) Syle Analysis 42

46 Keande, Gay, Powe and Sinclai (2005) Belgium, Gemany, Nehelands, Noway,Sweden, Swizeland and UK (weekly) 40 CAPM Timing: Heniksson- Meon(1981) MSCI Wold Index. 40 non-sri funds, mached by fund size, age, couny, and invesmen univese. Baue, Koedijk and Oen (2005) Gemany, UK and US CAPM MSCI Wold Index o DJ Susainabiliy Global Index (fo inenaional funds); 4384 non-sri funds (Gemany 114, UK 396, US 3874), including dead funds Caha (1997) FT All Shae Index o EIRIS ehical balance (fo UK domesic funds) Condiional: Feson and Schad (1996) S&P 500 o DSI 400 (fo US domesic funds) Renneboog, Te Hos and Zhang (2006) Baue, Oen and Touani Rad, (2006) 17 counies aound he wold CAPM Woldscope valueweighed Equiy Index Ausalia CAPM Caha (1997) Condiional: Feson and Schad (1996) Woldscope valueweighed Equiy index o Wespac Monash Eco Index 649 non-sri funds in he UK 281 non-sri funds including dead funds. Baue, Dewall and Oen (2006) Canada CAPM Caha (1997) Woldscope valueweighed Equiy Index o Janze Social Index 267 non-sri funds including dead funds. Condiional: Feson and Schad (1996) Bane and Salomon (2006) Renneboog, Te Hos and Zhang (2007) US 1995, 1997, 1999 (yealy) 67 Aveage eun 19 counies CAPM aound he wold Caha (1997) No benchmak index. Woldscope valueweighed Equiy Index No compaisons wih non-sri funds. 716 non-sri funds in he UK and 12,624 non- SRI funds in he US Condiional: Feson and Schad (1996) Timing: Teyno and Mazuy (1966) 43

47 Table 5: Empiical findings of SRI sudies This able summaizes he empiical findings of sudies on socially esponsible muual funds. Sudy Couny Findings Luhe, Maako and Cone (1992) Luhe and Maako (1994) UK The Jensen s alphas of ehical funds have mean of 0.03% pe monh (no significanly diffeen fom 0). Ehical funds have elaively high pofolio weighs on small-cap companies. UK The Jensen s alphas of ehical funds ae measued agains he FT All Shae Index o agains a Small-Cap Index. R-squaed is highe in he fis egession han he second one, which implies ha he SRI pofolio is biased owads small-caps. The aveage alphas measued in boh ways ae no significanly diffeen fom zeo. Hamilon, Joe and Saman (1993) Mallin, Saadouni and Bison (1995) Gegoy, Maako and Luhe (1997) Goldeye, Ahmed and Dilz (1999) US UK UK US Fo 17 SRI funds esablished befoe 1985, he aveage alpha is 0.06% pe monh, which is highe han he aveage monhly alpha ( 0.14%) of 170 non-sri funds (he diffeence is no significan). Meanwhile fo he 15 SRI funds wih shoe hisoy, i.e. esablished afe 1985, he aveage alpha is 0.28% pe monh, which is wose han he aveage monhly alpha ( 0.04%) of he coesponding 150 non-sri funds. The monhly alphas of ehical funds ange fom -0.28% o 1.21%, while 22 ou of he 29 alphas ae posiive. Alphas of non-ehical funds, 23 of which being posiive, ange fom -0.41% o 1.56% pe monh (diffeence is no saisically diffeen). The alphas of ehical funds ange fom 0.71% o 0.24% pe monh (almos all ae no significan). In a egession wih boh ehical and non-ehical funds, he ehical fund dummy does no have a significan impac on fund pefomance afe conolling fo fund age, size, and he make isk. Mos of he ehical funds have a significan exposue o he small-cap faco. The aveage Jensen s alpha of 29 SRI equiy funds is 0.49% pe annum, wheeas ha of 20 non-sri equiy funds is 2.78%. The diffeence is no significan. SRI funds using posiive sceens oupefom he SRI funds ha do no (he aveage monhly alphas ae 0.11% and 0.81%, especively, and he diffeence beween hem is saisically significan). Saman (2000) US The aveage monhly alpha is 0.42% fo SRI funds and 0.62% fo non-sri funds; he diffeence is no significan (-saisics = 1.84). The DSI 400 index has a highe Shape aio han he S&P 500 index (0.97 vs. 0.92). Schode (2004) Geczy, Sambaugh and Levin (2003) Keande, Gay, Powe and Sinclai (2005) Gemany, Swizelan d, and US US Euope The monhly alphas ange fom 2.06% o 0.87%. 38 ou of he 46 alphas ae negaive; only 4 of hem ae significan a 0.05 level. SRI funds do no significanly undepefom he benchmak pofolio consising of boh lage socks and small socks. Noe ha 11 ou of he 16 Geman and Swiss funds have highe exposues o he small-cap index han o he lage-cap index. Only 5 ou of he 46 funds have posiive iming abiliy, while 7 fund manages ime he make in he wong diecion. The aveage expense aio of SRI funds is highe han ha of non-sri funds (1.33% vs. 1.10%), wheeas he aveage annual unove of SRI funds is much lowe han ha of non-sri funds (81.5% vs %). The SRI funds have much smalle size han non-sri funds: he aveage asse unde managemen (acoss ime and acoss funds) is $149 million and $257 million especively. The monhly alpha of he SRI pofolio is highe han ha of he non-sri pofolio (0.21% vs. 0.08%), bu he diffeence is insignifican. Meanwhile, he isk exposue of he SRI pofolio o he size faco (SMB faco) is highe han ha of he non-sri pofolio (0.20 vs. 0.16).. To a make index inveso he financial cos of he SRI consain is 5 basis poins pe monh. The SRI consain imposes lage coss, moe han 1.5% pe monh, on invesos whose beliefs allow selecion skill. Moeove, fuhe esicing he SRI univese o he funds ha sceen ou sin socks (e.g. alcohol, obacco o gambling) inceases he monhly cos of he SRI consain by 10 basis poins o moe. The aveage Jensen s alphas of SRI and non-sri funds ae 0.20% and 0.12% pe monh, especively (diffeence is saisically insignifican). In addiion, he make iming coefficiens ae simila fo he wo ypes of funds (-0.29 vs. 0.28), and each of hem is significan a he 0.05 level. Howeve, he signs of he iming coefficiens ae negaive, which implies ha boh SRI and non-sri fund manages ime he make in he wong diecion. 44

48 Baue, Koedijk and Oen (2005) Renneboog, Te Hos and Zhang (2006) Gemany, UK, and US Ehical funds have smalle size and highe expense aio han convenional funds. The aveage monhly alphas of SRI funds ae 0.29%, 0.09% and 0.05% fo Gemany, UK domesic and US domesic funds, especively. The US domesic ehical funds significanly undepefom convenional domesic funds, while fo US inenaional funds he diffeence in euns beween ehical and convenional funds is insignifican. The UK ehical funds, boh domesic and inenaional funds, significanly oupefom convenional funds. The diffeence in aveage alphas beween Geman SRI and non-sri funds is insignifican. Oveall, hee is lile evidence of significan diffeences in isk-adjused euns beween SRI and non-sri funds. Fo Geman and US ehical funds: afe significan undepefomance in he ealy 1990s, hey mach convenional fund pefomance ove Olde ehical funds (launched befoe 1998) oupefom younge ehical funds. Geman and UK ehical funds ae heavily exposed o small-cap socks while US funds ae less so. All SRI funds ae moe gowh- han value-oiened. Ehical money chases pas euns. In conas o convenional funds invesos, SRI invesos cae less abou he funds isks and fees. Funds chaaceized by shaeholde acivism and by in-house SRI eseach aac moe sable invesos. Membeship of a lage SRI fund family ceaes highe flow volailiy due o he lowe fees o eallocae money wihin he fund family. SRI funds eceiving mos of he money-inflows pefom wose in he fuue, which is consisen wih heoies of deceasing euns o scale in he muual fund indusy. Finally, funds employing a highe numbe of SRI sceens o model hei invesmen univese eceive lage money-inflows and pefom bee in he fuue han focused funds. Baue, Oen and Touani Rad (2006) Baue, Dewall and Oen (2006) Bane and Salomon (2006) Ausalia Domesic ehical funds undepefom domesic convenional funds by 1.56% pe yea. Inenaional ehical funds oupefom hei convenional pees by 3.31% pe yea. None of hese diffeences ae significan. Canada The diffeence in aveage alphas is insignifican beween he SRI funds and non-sri funds (-0.21% vs. 0.18% pe monh). US When he numbe of social sceens used by an SRI fund inceases, he fund s annual eun declines a fis, bu ebounds as he numbe of sceens eaches a maximum. Renneboog, Te Hos and Zhang (2007) Woldwide Woldwide Consisen wih invesos paying a pice fo ehics, SRI funds in many Euopean and Asia-Pacific counies songly undepefom domesic benchmak pofolios. Fo insance, he isk-adjused euns of he aveage SRI funds in Belgium, Fance, Ieland, Japan, Noway, Singapoe, and Sweden ae on aveage less han 5% pe annum. Ehics is a disinc faco ha deemines he expeced equiy euns, consisen wih ehical fims being less isky. SRI invesos ae unable o idenify he funds ha will oupefom in he fuue, wheeas hey show some fund-selecion abiliy in idenifying ehical funds ha will pefom pooly in he fuue. SRI funds ae gadually conveging o convenional funds by holding a moe divesified ange of asses in hei pofolios. Finally, he sceening aciviies of SRI funds have a significan impac on funds isk-adjused euns and loadings on isk facos. 45

49 abou ECGI The Euopean Copoae Govenance Insiue has been esablished o impove copoae govenance hough foseing independen scienific eseach and elaed aciviies. The ECGI will poduce and disseminae high qualiy eseach while emaining close o he concens and ineess of copoae, financial and public policy makes. I will daw on he expeise of scholas fom numeous counies and bing ogehe a ciical mass of expeise and inees o bea on his impoan subjec. The views expessed in his woking pape ae hose of he auhos, no hose of he ECGI o is membes.

50 ECGI Woking Pape Seies in Finance Edioial Boad Edio Consuling Edios Edioial Assisans : Paolo Fulghiei, Pofesso of Finance, Univesiy of Noh Caolina & CEPR Fanklin Allen, Nippon Life Pofesso of Finance, Pofesso of Economics, The Whaon School of he Univesiy of Pennsylvania Paick Bolon, John H. Scully 66 Pofesso of Finance and Economics, Pinceon Univesiy, ECGI & CEPR Maco Pagano, Pofesso of Economics, Univesià di Saleno, ECGI & CEPR Luigi Zingales, Robe C. McComack Pofesso of Enepeneuship and Finance, Univesiy of Chicago & CEPR Julian Fanks, Copoaion of London Pofesso of Finance, London Business School & CEPR Xavie Vives, Pofesso of Economics and Finance, INSEAD & CEPR Paolo Casini, G.d Annunzio Univesiy, Chiei & ECARES, Lidia Tsyganok, ECARES, Univesié Libe De Buxelles

51 Eleconic Access o he Woking Pape Seies The full se of ECGI woking papes can be accessed hough he Insiue s Web-sie ( o SSRN: Finance Pape Seies Law Pape Seies hp:// hp://