management skills, which build up the relationships with stakeholders through social responsible actions (Moskowitz 1972). Thus, the less effective diversification effect would be offset by individual SRI stocks, which outperform the market over the long run (Barnett, Salomon 2006).
Furthermore, correctly implemented CSR will results in a competitive advantage over other firms.
The relation between CSR and competitive advantage is proposed by Porter, Kramer (2007). The authors claim that if CSR is incorporated into the firm’s strategy, it will generate opportunities, innovation and competitive advantage. Porter & van der Linde (1995) argue that proper environmental regulations could initiate innovations, which in the long run enhance resource productivity. Consequently, the enhanced resource productivity increases the firm’s competitive advantage. Hence, an increase of the firm’s financial performance.
The proponents argue that the relationship between Social Responsible Investments and financial performance is positive.
4.3. Modern Portfolio Theory
Markowitz (1952) introduced the framework denoted as Modern portfolio theory. The modern portfolio theory emphasizes the interaction among assets and the effect that diversification have on the entire portfolio’s risk level. The idea of efficient diversification maintains that any risk-averse investor will require the highest expected return for any level of portfolio risk. The assets included in a portfolio should be selected based on the covariance of these assets. Assets with low covariance to each other are desired in order to eliminate the firm-specific (non-systematic) risk (Markowitz 1952).
The assumption of “no free lunches” implies that you will have to accept a higher investment risk for higher expected returns. The concept based on this assumption is known as the risk-return trade-off in the securities markets, denoting that higher-risk assets are associated with higher expected returns than lower-risk assets (Bodie, Kane & Marcus, 2014).
Markowitz argues that there are several optimal portfolio combinations available from a set of risky assets that minimize the variance for any targeted expected return. All portfolios that lie on the efficient frontier, shown in figure 4.1, which starts at the global minimum-variance portfolio and upward, are considered to be portfolios with the best risk-return combinations. The optimal portfolio for the individual investor is chosen based on the investor’s level of risk aversion and expected return preferences. (Markowitz 1952).
Figure 4.1: Efficient frontier
As mentioned previously, the ethical screening process might reduce the diversification effect, since the investment universe is restricted. The ethical screening might exclude entire industries from the SRI fund portfolio, which will affect the opportunity of an adequate diversification.
Several studies have shown that the excluded industries tend to generate superior returns.
Historically, “sin” stocks in US, i.e. firms involved in gambling, production of alcohol or tobacco, have generated 9.1 % higher returns annually relative to the stock market, according to a study made by (Hong, Kacperczyk 2009). The results presented by (Tippet 2001, Borgers et al. 2015) support this over-performance of excluded industries in the negative screening process. According to the modern portfolio theory, SRI funds are expected to generate a lower risk-adjusted return for any given risk level than their conventional counterparts, since the risk-return trade-off is not optimized (Barnett, Salomon 2006).
4.4. Stakeholder Theory
R. Freeman (1984) challenged the prevailing shareholder view of a solely focus on profit maximization. A firm’s focus should lie on managing the relations with the parties that have any interest in the firm. An effectively implemented management of stakeholders will create superior financial performance. SRI firms take their stakeholders into consideration, since these corporations care about social or environmental aspects. (Barnett, Salomon 2006).
The concept of doing financially well, while doing socially good is a common goal for many investors. The risk of conflicts between corporations and society could be mitigated with effective stakeholder management. CSR actions to mitigate this risk leads to fewer conflicts, thus reduced costs for handling those conflicts and a higher financial performance in the long run (Heal 2005).
Barnett & Salomon (2006) proposes that the modern portfolio theory and stakeholder theory might be complementary. The authors find positive support for both theories. It is argued that if social screening is adequately implemented, higher risk-adjusted returns could be generated, even though SRI funds are operating within a limited investment universe. An intensive screening process identifies over-performing firms and eliminates firms with a poor track record. Hence, the superior returns from the identified SRI stocks offset costs from a poor portfolio diversification.
The degree of screening has an impact on the financial performance. SRI funds that employ limited social screens will benefit from the diversification effect, since the diversification increases.
However, ethical funds that neither employs many social screens nor a few, but something in between may not generate a better financial performance. The authors prescribe an intensive screen, which exclude socially irresponsible companies, or a broader screening strategy, which exclude only a few.
Figure 4.2: (Barnett, Salomon 2006)
4.5. The Efficient market theory
According to the Efficient Market Theory all available information about securities is immediately processed by the financial markets, i.e. the security price reflects all available information to investors, which can affect its value. The security price will adjust to its “fair” value, and would neither be over-priced nor underpriced. If a stock is forecasted to rise, investors will be eager to
buy the stock before the price jump. Thus, the increased demand for that stock will lead to an immediate increase of the price, instead of a future forecasted increase, i.e. any information which could be used to predict stock prices should already be reflected in the price. Therefore, stock prices follow a random walk, since the price only reacts to new information, which is unpredicted.
The concept that the stock price reflects all information is referred to as the efficient market hypothesis (EMH), where random price movements indicate an efficient market.
The idea of EMH is contradictive to the presence of active portfolio management. If the EMH holds would the actively managed funds never be able to outperform the market and the management fees could not be justified. A study of the difference in performance between the Wilshire 5000 index, which is a market-capitalization-weighted index that consists of all actively traded stocks in the US, and the performance of actively managed mutual funds show that the average annual return was 1 % higher for the index than for an average mutual fund. This result is in line with the EMH.
However, rational portfolio management has a purpose even in entirely efficient markets. Portfolio managers’ purpose is to construct well-diversified portfolios in order to eliminate firm-specific risk and customize the portfolio to the individual investors’ prerequisites (Bodie, Kane & Marcus, 2014).
4.6. Hypothesis formulation
Based on previous findings presented in the literature review and theoretical framework, the subsequent hypothesis will be examined throughout this study.
Hypothesis 1: SRI portfolios underperform conventional portfolios
In line with Markowitz’s modern portfolio theory should it be expected that the ethical mutual funds generate lower risk-adjusted returns than their conventional counterparts. As previously mentioned, this is due to the constrained investment universe, which SRI funds are operating in, where the diversification possibilities decrease. Subsequently, the mean-variance frontier shifts toward less beneficial risk-return trade-offs for SRI funds. Furthermore, it is assumed that the screening process tend to be more extensive for a fund with an ethical focus in comparison to a conventional fund, since the screening for ethical stocks is more time consuming. Those additional expenses could reduce SRI fund returns.
Hypothesis 2: SRI portfolios outperform their conventional peers.
Over the last years, Corporate Social Responsibility has become a central question for policy makers and investors, who demand that corporations should be responsible for the impact their decisions have on society and the environment. As previous discussed in the part concerning Stakeholder theory, firms that successfully implement stakeholder management could create superior financial performance. A firm with a sound SRI strategy signal good managerial skills, which translates into superior financial performance. Also, corporate social or environmental crisis could have a huge effect on companies, both financially and reputation wise. As mentioned previously, this risk is mitigated by fund managers through the ethical screening process of the stocks included in the mutual fund, where firm’s with effective stakeholder management should be selected.