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Social Responsibility and Fund Performance

Does social screening help or hurt returns?

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Socially responsible mutual funds, which eliminate or favor certain investments for moral or ethical reasons, have been around for decades. Nowadays investors can choose from a much wider variety of such funds than a generation ago, thanks in part to the larger, more diverse universe of mutual fund investors. Five years ago, we surveyed the range of socially responsible mutual funds now available, including both secular SRI funds and religiously oriented ones. While some individual funds have gone away and new ones have appeared since then, the broad structure of the field remains the same.

As more people have become interested in socially responsible investing, some of the most common questions that arise have to do with returns. Some people assume that social screens must hurt fund returns, while others suspect that such screens can actually help--that's it's possible to "do well while also doing good." The situation is actually a bit more complicated than either of these claims.

Good Funds, Bad Funds
First of all, it's not appropriate to lump all SRI funds into one undifferentiated mass--there are good SRI funds and bad SRI funds, just as in any other group. In that sense, it is possible for SRI investors to outperform over time, if they pick strong funds run by managers with proven track records. Russ Kinnel looked at four good ones here, and Christine Benz recently looked at three other solid SRI funds with diversified portfolios here.

But this raises the question of whether the social screens have anything to do with these funds' good returns, or whether it's primarily the manager's skill. Indeed, the managers of two of the funds mentioned in the above articles ( Amana Trust Growth (AMAGX) and  Neuberger Berman Socially Responsive (NBSRX)) manage very similar non-SRI funds that also have very strong track records. For instance, Neuberger Berman Socially Responsive and non-SRI sibling  Guardian (NGUAX) have almost identical returns in the nine-plus years that Arthur Moretti and his team have managed both funds, both ranking in the large-growth category's top 30% during that time.

Some social screens certainly can help or hurt short-term fund performance in certain market environments. A good example is the  Domini Social Equity (DSEFX) fund, which until 2006 tracked the KLD 400 Social Index. That index excludes many energy and industrial stocks for environmental reasons, and is usually heavier than the broader market in technology stocks, which tend to score well on environmental, diversity, and employee-relations measures. Domini Social Equity handily outperformed the S&P 500 index in the tech-led bull market of the late 1990s, but then it trailed the index in the subsequent bear market, when tech was among the worst-performing sectors.

It's a similar story at  Vanguard FTSE Social Index (VFTSX), which tracks the FTSE4Good U.S. Select Index. That index is similarly light in energy and industrial stocks but especially heavy in financials, which have typically made up more than 20% of the fund's assets, much more than the large-growth category average. That big financial weighting hurt the fund in 2007 and 2008, when financial stocks got hammered, but helped it in 2009, when financials were among the leaders of the market rebound.

Over the long term, these ups and downs even out. In a study published in the Fall 2011 Journal of Investing, Lloyd Kurtz and Dan DiBartolomeo showed that the performance of the KLD 400 from 1992 to 2010 was essentially indistinguishable from that of the S&P 500 Index, after accounting for sector weightings and a slight growth bias.

Social Screening: Plus, Minus, or Neutral?
This last example raises the question of whether social screens have any real effect on long-term fund returns, positive or negative, once manager skill and other factors are abstracted out. Modern portfolio theory says that they should hurt, because anything that makes an investment universe less diversified results in a lower expected return for a given level of risk. In practice, though, it has been surprisingly difficult to prove that social screens make any significant long-term difference to investment returns.

Quite a few academic studies over the past 20 years have looked for such differences and failed to find them. Among the first of these was a 1993 study by Hamilton, Jo, and Statman, which found no significant difference in the risk-adjusted returns of socially screened versus unscreened mutual funds. Meir Statman came to a similar conclusion in a 2000 follow-up study covering the 1990-98 time period, as have subsequent authors such as Bauer et al (2002) and Bello (2005).

Some of these studies have found minor ways in which SRI funds as a group differ from the broader market, but none of these is worth worrying about for ordinary investors. In essence, these studies have found that social screening is a "free good". If you're considering a socially responsible mutual fund, you should definitely look at whether its screening agrees with your principles, along with factors that are useful in evaluating any mutual fund, such as manager track record and expenses. As the Domini and Vanguard examples above illustrate, social screening can have an effect on a fund's risk profile and result in short-term deviations from the broader market; over the longer term, though, there's no need to worry about whether screening itself will hurt your returns.

David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.