Mutual Funds Can Improve Performance by Investing in Responsible Firms

Mutual Funds Can Improve Performance by Investing in Responsible Firms

Selecting mutual funds that screen irresponsible firms reduces portfolio diversity but can improve long-term financial performance.
Lauren Rakowski August 30, 2010
Your firm's financial performance can be improved through socially responsible investing (SRI) - using mutual funds to invest in companies with strong CSR strategies that demonstrate responsible corporate citizenship.

A study by Michael Barnett of Rutgers Business School and Robert Salomon of NYU's Stern School of Business examines the relationship between SRI and financial results in mutual funds, measuring how social screening used by SRI funds affects financial performance.

Screening for Sustainability

Mutual funds that with SRI components often choose firms with good CSR - enforced environmental policies, a strong record of community involvement, and fair employee practices. However, if a fund's social performance criteria is too strict, it will exclude certain firms, leading to a less diversified portfolio and therefore greater risk on returns. Thus funds are also concerned with diversifying; fewer social responsibility screens mean stronger financial performance due to the ability to hedge greater risks with a more diverse portfolio. The funds that occupy the "middle ground" between these two extremes (e.g. using a medium social performance screen) yield relatively poor financial results.

The authors used modern portfolio and stakeholder theories to measure the link between financial and social performance in mutual funds practicing SRI. They conducted an empirical test on 61 SRI funds from 1972-2000. The US Social Investment Forum (a national non-profit organization that encourages and promotes the growth of socially responsible investing) gave information about the number and type of screening strategies of funds. CRSP data tracked each fund's financial performance and was supplemented with mutual fund information from Weisenberger and ICDI (both mutual fund tracking services that provide a standard directory of information on mutual funds and their holdings).

Three Important Findings Emerge

This research explains how portfolio and stakeholder theories can be complementary. However, the majority of funds examined were less than five years old, so long-term financial outcomes cannot be known. A firm's up-front investments in environmental improvements, for example, may take years to pay off. Researchers should also note that the market's preference for social screens may change in upcoming years. Future research can examine the merits of different types of screening strategies in more depth.

Screen Big or Go Home

As a manager, you must either commit to broadly screening out socially irresponsible firms from your funds, keeping only top performers, or exclude very few firms to maintain your ability to diversify.

Be aware of changes in which social screens are being rewarded in the market, and pay attention to long-term trends since social initiatives may have extended payback periods.
Barnett, M., & Salomon, R. 2006. "Beyond Dichotomy: The Curvilinear Relationship Between Social Responsibility and Financial Performance." Strategic Management Journal.27.11: 1101-1122. 

additional resources

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Joyce Shang
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Managers can evaluate which are the most mutually-beneficial social causes to become involved with – and which ones their firm should avoid.

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