The effect of social screening on bond mutual fund performance
Introduction
The consideration of corporate social responsibility (CSR) in investment decisions is becoming an increasingly important process for investment decisions. Socially responsible investments (SRI) complement conventional portfolio optimization with the integration of environmental, social and governance (ESG) criteria. In practice, SRI fund managers filter their investments using ESG ratings to achieve portfolios with social attributes. This study investigates the extent to which screening for CSR or ESG criteria has an effect on the financial performance of bond portfolios. We believe this is a relevant question for a number of reasons. First, the considerable market size of SRI fixed income investments, along with the increasing attention paid to socially responsible bond investing in practice, are arguments for more empirical research on this market segment. The market for SRI has grown to a substantial segment of investments due to very high growth rates in the past 20 years. In 2016, there are more than 1440 institutional investors worldwide who are signatories to the United Nations-backed Principles for Responsible Investing. These signatories commit themselves to integrate ESG criteria into their investment processes; they include investment managers with 12.4 billion USD of assets under management or 19% of the global asset market. Thereof, SRI fixed-income investments account for the largest asset class. With the amount of money invested in SRI and the attention that an increasing number of retail and institutional investors are giving to CSR, it is important to understand the extent to which the integration of CSR or ESG criteria in investment decisions affects financial returns.
Second, it is important to know whether there is a trade-off between financial and non-financial investment objectives. If ESG screening of bond portfolios has a negative effect on financial performance, investing in SRI will create a potential breach of fiduciary duty. In the event of negative return implications caused by ESG screening, only asset managers with the mandate to screen for ESG could apply this approach without running the risk of committing misconduct related to their fiduciary duties. Conversely, if there are beneficial return effects from ESG screening, fiduciary duties instead suggest integrating ESG screening into portfolio management. If ESG screening has no return effect, SRI bond funds offer only non-financial attributes that address specific investors’ taste.
Third, litigation risks related to ESG criteria are becoming increasingly material for companies. To cite an example related to increasing environmental risks, the number of climate-related events that cause severe losses has increased from fewer than 400 events per year in the 1980s to more than 800 events per year after 2000. Consequently, losses related to such events are constantly increasing, exceeding 200 billion USD in some recent years.1 Social risks such as substandard worker conditions and safety standards can interrupt corporate supply chains or cause physical harm. For example, the April 2013 collapse of the Rana Plaza factory building in Bangladesh was followed by a consumer outcry to avoid products that are manufactured under unsafe conditions. Probably the most prominent examples of corporate governance risks are financial institutions’ litigation payments, which have exceeded 275 billion USD since the financial crisis. Over time, the increasing materiality of ESG risks for companies emphasizes the relevance of ESG risk mitigation for investment portfolios.
Fourth, we observe different ESG screening approach among bond compared to equity SRI portfolio managers. SRI equity fund managers aiming to identify companies that might outperform the market usually focus their attention on the most sustainable or responsible companies. Because of their strong emphasis on risk reduction, SRI fixed-income fund, in contrast, avoid only the most unsustainable or irresponsible companies. Thus, even though SRI bond and equity funds both apply the same ESG data, their screening processes differ tremendously. Prominent examples of these different screenings involve common sustainability benchmark indices. The Dow Jones Sustainability (equity) index is defined as the selection of the 10% most sustainable companies in each industry. In contrast, the Barclays MSCI Corporate Sustainability (bond) index includes 50–75% of the most sustainable companies, i.e., only the 25–50% most unsustainable companies are filtered out. We consider these benchmark indices as representative of the most common SRI equity and bond investment approaches. Thus, an investigation of SRI bond funds is not expected to simply provide empirical findings on a particular asset class. More precisely, in contrast to SRI equity fund studies, we assess whether the bottom end of the sustainability rating scale has economic relevance to investments’ financial performance.2 Specifically, we investigate whether just the exclusion of bond issuers with the lowest ESG ratings has an effect on the financial performance of bond portfolios.
This study primarily aims to investigate any ESG screening-related return effect using a representative sample of 103 SRI and 309 matched conventional bond mutual funds from the US and the Eurozone. In particular, our study relies on all of the SRI corporate bond funds that are listed on current or historic fund lists provided either by the US Social Investment Forum (US SIF) or the European Social Investment Forum (Euro SIF). We test the hypothesis that screening for ESG criteria has an effect on financial performance. Moreover, this investigation of a potential effect of ESG screening on bond portfolio returns indirectly answers the question of whether ESG risks are material influence factors for corporate bond returns.
Many studies have assessed the financial performance of SRI equity investments. The results of these studies are mixed. Generally, there appears to be no significant difference between the financial performance of SRI funds and that of conventional equity funds.3 Such findings are in line with the view of Cheng et al. (2014) and Di Giuli and Kostovetsky (2014) that investments in CSR activities are not generally positive net present value activities from the perspective of shareholders. Flammer (2015) investigates shareholder votes on CSR proposals and identifies that the only types of proposals that have a high level of acceptance among shareholders relate to initiatives to overcome labor issues (e.g., nondiscrimination or fairness policies) and initiatives to mitigate environmental hazards. Both this study and Krueger (2015) find a positive effect on shareholder value of CSR initiatives that aim to overcome corporate irresponsibility. Apparently, CSR is of more economic relevance for companies with poor CSR activities than for companies with strong ones. In addition, several pieces of recent evidence support a risk-reduction view of CSR. Koh et al. (2014), for example, identify that strong CSR activities (such as sincere corporate governance, good environmental management, and employee satisfaction) decrease future litigation risks. Moreover, Godfrey et al., 2009, Goss and Roberts, 2011, El Ghoul et al., 2011 and Bouslah et al. (2013) provide empirical evidence suggesting that strong CSR activities reduce idiosyncratic firm risks. Stellner et al. (2015) complement that CSR is rewarded in the corporate bond market especially in countries with above average ESG ratings. Bhojraj and Sengupta, 2003, Klock et al., 2005, and Chava et al. (2009) find that strong corporate governance mechanisms provide benefits to bond investors, whereas, for example, antitakeover provisions add no value. Kim et al. (2014) and Callen and Fang (2015) identify a higher stock-price crash risk for companies with weak corporate governance monitoring mechanisms or insufficient accounting transparency. Sharfman and Fernando, 2008, Bauer and Hann, 2011, and Chava (2015) measure a higher cost of debt and weaker credit ratings for companies with higher environmental risks or poor environmental management. Moreover, Edmans (2011) and Derwall et al. (2011) argue that the average capital market participant underestimates the importance of ESG issues. Therefore, CSR activities are neither timely nor efficiently incorporated into market prices. Once the economic influence of such issues materializes, stocks of companies with low ESG ratings decrease and vice versa. Koelbel and Busch (2013) complement this view and identify negative stock price reactions to negative media news on corporate ESG issues. We believe these arguments are of even greater relevance for bond investments, because bonds are generally less efficiently priced than stocks.
We contribute to the discussion of SRI and ESG’s economic relevance with an economically and statistically significant outperformance of 0.33–0.49% annually of SRI compared to conventional bond funds during the period 2001–2014.4 We argue that this result is the outcome of a systematic effect of social screening on financial performance caused by the hypothesized risk reduction conferred by CSR activities in combination with SRI bond funds’ exclusion of irresponsible corporate bond issuers.
To further explore the outperformance of SRI bond funds, we evaluate fund portfolio holdings by matching each corporate bond position with an ESG rating. This allows us to measure ESG risks at the portfolio level using sustainability ratings from Sustainalytics.5 We reveal two findings on SRI bond funds. First, one-third of funds that claim to be socially responsible invest in portfolios with ESG ratings below the average of conventional funds. We consider these conventional funds as in disguise. Second, the remaining two-thirds of funds appear to integrate ESG criteria by especially excluding bonds of companies with very low ESG ratings. The direct assessment of the exposure of each fund portfolio to ESG risks allows for a more precise performance measurement of only those SRI bond funds that conduct an ESG screening. Consistent with our hypotheses, SRI bond funds with an ESG screening are particularly likely to outperform by 0.58–0.70% annually. The returns of the remaining SRI bond funds show no difference from conventional funds. To further test whether there is a systematic effect of social screening on financial returns, we conduct multifactor model regressions with an ESG screening-related return factor. After controlling for this ESG-specific factor, fund alphas of SRI bond funds decline significantly. As the next step, we apply this ESG return factor in a performance-attribution analysis. It turns out that the ESG screening component explains 8–10% of the return variation of SRI bond funds. Thus, the return variation that arises from the bond portfolio ESG screening explains a significant share of the active return.
By looking at different market regimes, we further investigate whether the outperformance of SRI bond funds relates to a potential risk-reduction effect of CSR. More specifically, the risk-mitigation view assumes that bond issuers with high ESG ratings manage ESG risks more effectively and therefore are less exposed to risks. Shefrin and Statman (1993) and Hirshleifer (2008) find that investors examine firm risks and corporate behavior more closely when the economy is weak. If investors indeed pay greater attention to ESG risks in times of crisis, we infer that any positive effect for bond portfolio performance caused by ESG screening should be especially likely to occur during crisis periods such as economic recessions or bear markets. In line with this argument, Nofsinger and Varma (2014) show a downside risk-reduction effect for SRI equity investments caused by SRI equity funds’ outperformance during stock market crises. Lins et al. (2015) argue that companies can build trust among their investors with strong corporate social responsibility (CSR) activities. They find a strong outperformance of companies with strong CSR during the financial crisis, but no return difference between high and low CSR companies either before or after the crisis period.
In this study, we identify a strong outperformance for SRI bond funds during crisis periods of 0.65–0.74% for the US sample and of 0.77–0.92% for the Eurozone sample. In turn, the return difference of SRI bond funds compared to conventional funds in non-crisis periods is smaller and, especially during non-bear market periods, statistically insignificant. Thus, the outperformance of SRI bond funds during the period 2001–2014 arises because of the sequence of three crisis periods: the burst of the dot-com bubble in 2001–2003; the financial crisis in 2008–2009; and the Eurozone sovereign debt crisis, especially in the years 2011–2012. In conclusion, our findings provide additional empirical evidence for the risk-reduction view of CSR activities.
In the final section of the paper, we perform several robustness checks. Potential alternative explanations for our results include variations in fund manager skills, omitted risk factors, investment styles, cross-sectional differences in fund characteristics, differences in social screening over time and across funds and a SRI label effect. Overall, the identified effects of social screening on bond fund returns are consistent for the US and Eurozone samples and robust to the application of various factor models, alternative sustainability ratings, annual fund portfolio evaluations, various fund-level control variables, potential SRI label effects and survivorship bias. Moreover, we reconfirm a crisis period related return effect from ESG screening out-of-sample among socially screened corporate bond indices in comparison to conventional bond indices.
The remainder of this paper includes a market and data overview in Section 2; empirical results on financial performance, portfolio holdings and performance attribution on SRI bond funds in Section 3; a discussion of alternative explanations and robustness tests in Section 4; and a conclusion in Section 5.
Section snippets
Market and data overview
This study focuses on corporate bond mutual funds in the two largest markets, the US and the Eurozone, because of those markets’ high level of transparency and data availability. The market for SRI has grown to a considerable segment of investments because of those investments’ very high growth rates. According to the US SIF 2014 Report on Sustainable and Responsible Investing Trends in the United States, the SRI market reached 6.6 trillion USD in total assets under management by the beginning
Financial performance measurement
For the financial performance measurement of bond funds, a five-factor model is applied that combines the approaches of Cornell and Green, 1991, Blake et al., 1993, Fama and French, 1989 and Elton et al. (1995). The five factors include an AGGREGATE, a DEFAULT, an EQUITY, an OPTION and a TERM factor. The AGGREGATE factor consists of the excess total returns of a US broad investment-grade corporate bond index over one-month treasury yields. The DEFAULT factor is based on the excess total returns
Out-of-sample robustness and fund manager skills
As our first robustness test, we check whether the ESG screening-related return effect, as identified in the previous section, exists out-of-sample among ESG-screened bond indices. If we do not observe a comparable return effect, the SRI bond fund-specific financial performance might arise from fund manager skills instead of a systematic effect of ESG screening. In Table 8, we display bear market and non-bear market returns of US and Eurozone corporate bond indices with and without a social
Conclusion and implications
This study provides the first comprehensive empirical assessment of the financial performance of ESG-screened bond funds. SRI bond funds outperform conventional funds by one-half of one percent during the period from 2001 to 2014. With a portfolio holdings evaluation, we can further specify that only SRI funds that apply ESG screening generate this outperformance. More specifically, fund managers of these funds appear to exclude bond issuers with the highest ESG risks, as indicated by the
Acknowledgement
We gratefully acknowledge constructive comments of an anonymous associate editor and anonymous referees, Marie Briére, Pascal Coret, Simon Gloßner, Roberto Liebscher, Valeria Miceli, Thomas Mählmann, David Nanigian, Ioannis Oikonomou, Philipp Rindler, Martin Rohleder, Bert Scholtens as well as from participants and reviewers of the 2014 World Finance Conference, the 2014 IFABS Conference, the 2014 BAFA Annual Conference and the 2013 PRI Academic Network Conference. Furthermore, we thank
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