Do socially responsible investments strategies significantly reduce diversification benefits?

Abstract

The performance of Socially Responsible Investments (SRI) funds is one of the hottest debate in SRI research. As the process of constructing SRI funds employs many non-financial criteria, the performance of SRI might be influenced because of lack of diversification. With socially responsible consideration, the construction of SRI is restricted by many non-financial criteria. Therefore, the diversification of SRI funds would be reduced in two ways. Firstly, investment may be constrained in certain highly correlated scope. Secondly, some good investment opportunities may be excluded by the non-financial criteria. Using a number of screening criteria to measure the screening intensity, most studies found that the number of screens negatively impacts SRI fund performance. This research is motivated to answer a beleaguering question - do social, ethical, environmental and corporate governance friendly consideration and non-financial criteria employed in screening social responsible investment reduce SRI diversification benefits? There are three research questions answered by this paper. First, this paper studies whether the diversification of SRI funds is significantly different from the diversification of peer conventional funds. Peer conventional funds are selected with matching fund approach by considering fund domicile, year of inception and funds size. Diversification degree of fund in this paper is measured by six variables: the number of stocks, the percentage of top 10 holdings, and asset allocation in cash, bond, and equity. Both Mood’s median test and Student’s t-test are used in this paper to examine the significance of difference in diversification between SRI funds and peer conventional funds. Second, this paper investigates whether the influence of socially responsible screening criteria on SRI funds diversification is significantly negative. The results of t-test indicate whether the difference in diversification between SRI and conventional funds is significantly negatively. Third, this paper observes the diversification difference between environmental focus SRI funds and environment, social, and governance (ESG) focus SRI funds to determine whether the difference in diversification benefits of these different group of funds (with different screening strategies) is statistically significant. Both Mood’s median test and t-test are applied in this part. As the group of environmental focus SRI funds and the group of ESG focus SRI funds are different in size, independent t-test for means is used in this comparison. Based on maturity of SRI market and data availability, empirical research on social responsible investment is mainly concentrated in the US and some developed European countries. However, economic growth in Asia-Pacific region is rapid and prominent, and the SRI markets in Asia are full of potentiality of development. To fill the gap on SRI research and explore SRI developing in emerging market, this study expands SRI research to Asia-Pacific region. This study uses data gathered from Morningstar and Datastream for a period of 13 years from 2004 to 2016 on five Asia-Pacific countries (United States, South Korea, Japan, Australia and China). This paper contributes to the literature on SRI funds in three aspects. First, unlike most studies on SRI funds that focus on performance of SRI funds, this paper highlights the diversification benefits of SRI funds. Second, unlike most studies that focus on US and European markets, this paper expands research in Asia-Pacific region. The five countries selected are top five countries in the Asia-Pacific region that have highest number of socially responsible funds in Morningstar. A total of 721 SRI funds included in this study represents 90 percent of total SRI funds in Asia-Pacific region. Third, this paper provides a cross-country analyses on SRI diversification between the five countries selected. Findings of this paper show that diversification between SRI and conventional funds, as well as, environmental focus SRI funds and ESG focus SRI funds were significantly different, but the influence of SRI screening on fund diversification are not all negative. Such results support findings in some paper on SRI fund performance that SRI funds do not significantly underperform conventional funds.