2.0 Introduction

This chapter reviews the literature relating to socially responsible investment in a funds management context. A quick review of funds management, specifically mutual funds is presented in Section 2.1. This is followed by a brief introduction to socially responsible investment (SRI) funds in Section 2.2, which includes an explanation of the investment screening approach used by these funds. Following this, Section 2.3 summarises the existing evidence on the performance of SRI funds relative to non-SRI funds. Thereafter, Section 2.4 examines how variation in screening intensity affects performance of SRI funds, while Section 2.5 examines how this variation affects the flow-performance relationship of fund flow into SRI funds. Finally, we draw together the extant literature and outline the contribution of this dissertation to the literature (Section 2.6).

2.1 Funds management – mutual funds

A mutual fund is a company that pools money from many investors and invests money in stocks, bonds, short-term money market instruments, or other securities. [1] Investors purchase units of these funds. Funds are managed by professional fund managers who trade the fund’s investments based on its investment objectives. Mutual fund managers and investors generally have different objectives – managers are concerned with money-inflows and the resulting management fees, while investors desire high risk-adjusted return on their investment at low fees.

Early studies show that investors rely heavily on past performance (Capon et al.., 1996) and both new and old shareholders react to past performance (Johnson, 2006). Therefore, good performing funds receive increased cash flows, leading to higher manager compensation (Chevalier and Ellison, 1997; Sirri and Tufano, 1998). However, the reaction of investor flow to fund performance is not identical in both directions – the best performing funds receive the largest share of fund inflows but the poor performing funds do not experience equivalently large outflows (Ippolito, 1992; Sirri and Tufano, 1998). This suggests that once money is invested in a fund, it tends to be relatively sticky (Gruber, 1996). The flow-performance relationship is also more prominent in funds that engage in marketing activities or receive greater media attention as fund investors are generally not trained in portfolio analysis and base their investment decision on published information (Sirri and Tufano, 1998).

2.2 SRI funds

Socially responsible investment (SRI) can be defined broadly as ‘an investment process that considers the social and environmental consequences of investments, both positive and negative, within the context of rigorous financial analysis’ (Social Investment Forum, 2007). Often called ethical investments or sustainable investments, this type of investment has become increasingly popular in recent years. According to the Social Investment Forum, the number of SRI funds in the US have increased from 55 in 1995 to 260 in 2007, now accounting for an estimated $2.71 trillion out of $25.1 trillion invested in the U.S. investment marketplace. [2]

There is a variety of choices for the US socially responsible investor. In fact, there are now even socially responsible indexes that have been created. [3] Since the launch of KLD Research & Analytics, Inc.’s pioneering Domini 400 Social Index (DSI 400) in 1990, which is modeled on the S&P 500 Index, there are 17 different socially and environmentally screened index funds today.

2.2.1 A brief history of SRI

The early stages of the SRI movement can be traced back to the nineteenth century, especially amongst religious movements such as the Quakers and Methodists. Specifically, these groups excluded investments that would go against their beliefs. [4] Knoll (2002) records that such non-financial ‘exclusionary’ behavior in investment choice became a highlight in 1960s during the Vietnam War, where funds like the PAX World Fund was set up with a mission to avoid any investments that derive profits from weapons production. Another milestone moment for SRI occurred in the 1980s – investors who were against the apartheid regime in South excluded any investments in South Africa.

2.2.2 Screening

The most common factor that distinguishes a SRI fund from a non-SRI or conventional fund is the use of social criteria as part of the portfolio construction process. According to Knoll (2002), ‘SRI means only that nonfinancial criteria are part of the selection process for choosing investments’.When creating a socially responsible portfolio, a fund manager first analyses the entire universe of investments against non-financial criteria to establish a subset of investments that are acceptable in terms of investors’ ethical, social, religious or other preferences. In the SRI industry, these non-financial criteria are referred to as screens.

Investment screens generally fall into either one of two categories – positive or negative screens. Negative screens can be thought as avoidance or exclusionary screening. The most popular examples of negative screens include tobacco, alcohol, gambling or weapons, most of which are associated with the traditional type of screening against ‘sin’ industries.

On the other hand, positive or inclusionary screens aim to select shares that meet superior corporate social responsibility (CSR) standards. This can be thought of as ‘best-in-class’ in terms of performance in a particular social cause. Most popular examples of positive screens relate to issues about the environmental sustainability, human rights advocacy and community involvement. Today, it is most common for funds to use a combination of both positive and negative screens. [5]

2.3 Performance and SRI mutual funds

2.3.1 Performance benchmarks

To date, much of the academic research on socially responsible investments focuses on analyzing their performance. For mutual funds, the Jensen’s alpha is a popular measure for performance. This traditional approach of evaluating performance introduced by Jensen (1968) is cond