How Ethical Compliance Affects Portfolio Performance And Flows: Evidence From Mutual Funds

Sadok El Ghoul

University of Alberta – Campus Saint-Jean

Aymen Karoui

University of Quebec at Montreal (UQAM) – Faculty of Management (ESG)

December 4, 2015

Abstract:

We study the effects of corporate social responsibility (CSR) on fund performance and flows. Using an asset-weighted composite CSR fund score based on firm-level ratings, we find that funds with high CSR scores display poor performance and strong performance reversal. Furthermore, high-CSR funds exhibit weaker performance-flow relationships and slightly stronger flow persistence. All these findings are consistent with investors in high-CSR funds deriving utility from non-performance attributes.

How Ethical Compliance Affects Portfolio Performance And Flows: Evidence From Mutual Funds – Introduction

Whether compliance of mutual funds with ethical standards improves or reduces performance is an important, long-standing question in the mutual fund literature.1 This debate has further increased in intensity in light of the tremendous growth in socially responsible investment (SRI) funds. According to the Social Investment Forum (SIF), US SRI assets under management registered an increase from 639 $B in 1995 to 3,744 $B in 2012, and an increase in their relative market share from 9% to 11% over the same period.2 Despite this striking growth, the literature has reported no astonishing return performance for US SRI funds.

To examine the impact of compliance with ethical standards on fund performance, the mutual fund literature has adopted a dichotomous approach by comparing a group of funds that fully comply with ethical standards (i.e., SRI funds) to the remaining funds that are called conventional funds. However, in comparing SRI to conventional funds, the literature compares two samples with unequal sizes and dissimilar characteristics. It also ignores the amount of heterogeneity within each category (e.g., Barnett and Salomon, 2006). To overcome theseissues, the current paper suggests a simple holdings-based measure to assess the level of corporate social responsibility (CSR) of a fund. The measure is a value-weighted score using firm-level ratings of portfolio holdings. Armed with this tool, we are able to examine the impact of ethical compliance on performance on a continuum basis, without resorting to the dichotomous categorization into SRI and conventional funds. Consequently, we are able to compare funds, based on the CSR criterion, cross-sectionally and across time. The measure can be used as an additional attribute by mutual fund investors.

In examining the relationship between ethical compliance and fund performance, two hypotheses compete: On the one hand, investing in firms that comply with social responsibility practices is likely to reduce the set of investment opportunities (Geczy, Stambaugh and Levin, 2005; Renneboog, Ter Horst and Zhang, 2008b; Cortez, Silva and Areal, 2009) and to increase monitoring costs (Bauer, Koedijk and Otten, 2005). Ethical compliance would then negatively impact financial performance. On the other hand, fund managers that target socially responsible firms may in fact target firms with solid financial fundamentals, which in turn would translate into higher performance. In this case, investing in socially responsible stocks would be a valuegenerating strategy.

At the empirical level, the literature has nonetheless reported mixed evidence as to the existence of a significant difference in performance between the SRI and conventional funds in the US market. For instance, Bauer, Derwall and Otten (2007) find that domestic ethical US funds significantly underperform conventional funds, while Gil-Bazo, Ruiz-Verdú and Santos (2010) report an opposite finding. Nofsinger and Varma (2014) find that SRI funds outperform their conventional peers during times of crisis and underperform at other times. However, most of the studies on US mutual funds find no statistical difference in performance between SRI and conventional funds (e.g., Hamilton, Joe and Statman, 1993; Goldreyer and Diltz, 1999; Statman, 2000; Schroder, 2004; Geczy, Stambaugh and Levin, 2005; Renneboog, Ter Horst and Zhang, 2008b). We contribute to this debate on the impact of ethical compliance on fund performance. However, instead of comparing SRI to conventional funds in a dichotomous way, we suggest a finer fund-level analysis using portfolio holdings, as defended by Borgers, Derwall, Koedijk and Ter Horst (2015). We are thus able to shed light on the potential interaction between CSR and fund performance without resorting to potentially biased matching procedures and conflicting SRI screening processes.