The Impact of Social Screening on the Performance of US and European Funds

Introduction

During the last decades, sustainable investments have experienced a substantial growth in financial markets.¹ The well-known corporate and environmental scandals of the beginning of the millennium and the events associated to the 2007-2008 international financial crisis have led to calls for reconsidering the role of finance in society, in particular the need to promote socially responsible corporate behavior and sustainable investments. Accompanying this trend, investors are increasingly willing to integrate non-financial criteria into their investment decisions to reflect their sensitivity to issues such as emissions control, global warming, human rights, labour relations and board diversity. Several recent papers investigating the drivers of sustainable investments confirm that social preferences are more important than financial motives in the decision to invest in socially responsible investment (SRI) funds (e.g., Riedl & Smeets, 2017). This evidence is consistent with a segment of values driven investors that wish to incorporate their social and personal values into their investment decisions (Derwall et al., 2011), even if it comes at the cost of lower returns. Nevertheless, the mainstreaming of sustainable investments is anchored with an approach that accommodates investors who wish to integrate Environmental, Social, and Governance (ESG) issues into traditional asset management as a strategy to generate profitability (Derwall et al., 2011; Revelli, 2017). The increasing growth of socially responsible investing around the world has led to an intense debate on whether there is a financial premium or penalty for holding SRI funds, with empirical evidence showing that, in general, investors do not sacrifice performance compared to conventional funds (Revelli & Viviani, 2015). Additionally, from the investor’s point of view, selecting companies with high levels of CSR can be viewed as a useful risk management tool, as there is evidence documenting the portfolio risk mitigating effects of ESG integration (e.g., Maxfield & Wang, 2020). As such, managing ESG risks plays an important role in the investment process, regardless of the motivations underlying SRI.

Despite the profusion of funds with sustainability features, there is still ambiguity on what makes a mutual fund socially responsible. The answer to this question is not straightforward, as there is no single and universal definition of what criteria a mutual fund should follow to be considered an ethical or socially responsible fund (Dunfee, 2003). SRI funds can use several social screening strategies. Negative screening strategies exclude stocks that are associated with products or activities considered socially unacceptable, while positive screening strategies involve selecting stocks of firms meeting superior standards on several dimensions of corporate social responsibility. To avoid possible diversification biases, such as the exclusion of entire industries, a popular screening strategy is the best-in-class strategy, which involves selecting the companies with best social practices in each sector. Besides using different screening strategies, SRI funds can also vary on the type of screens used (e.g., of the environmental or social type) and the number of screens used (i.e., screening intensity). Combining different screening strategies, types of screens, and the number of screens used by mutual funds may result in different understandings of the objectives the screening process encompasses and leads to considerable heterogeneity in the SRI fund landscape (Sandberg et al., 2009). Ultimately, the degree of heterogeneity in the criteria used by SRI funds reflects the wide diversity of investors’ values. Despite the heterogeneity of SRI funds, many studies treat them as being homogenous. According to Galema et al. (2008) and Derwall et al. (2011), among others, one of the reasons why the empirical literature finds scarce significant relations between socially responsible investments and returns is the aggregation of different social dimensions that may have confounding effects in financial performance. We argue that the heterogeneity within the SRI fund industry in terms of the screening processes used should be considered when investigating the impact of social criteria on mutual fund performance.