Portfolio Constraints and Market (In)efficiencies
SRI applies various screening processes to retain stocks complying with specific CSR criteria on social, corporate governance, environmental, and ethical issues, which imposes a constraint on the investment universe available to non-SRI investors. SRI screens may therefore limit the diversification possibilities, and consequently shift the mean–variance frontier toward less favorable risk–return tradeoffs than those of conventional portfolios. In addition, believers in the efficient market hypothesis argue that it is impossible for SRI funds to outperform their conventional peers. Screening portfolios based on public information such as CSR issues cannot generate abnormal returns.
However, it is also possible that SRI screening processes generate value-relevant information which is otherwise not available to investors. This may help fund managers to select securities and consequently generate better risk-adjusted returns than conventional mutual funds. In this case, investors may do (financially) well while doing (social) good, i.e. investors earn positive risk-adjusted returns while at the same time contributing to a good cause. For instance, empirical research on CSR shows that portfolios constructed with reference to corporate governance, environmental, and social criteria may outperform their benchmarks.
A key assumption underlying the above hypothesis is that the stock markets misprice information on CSR in the short run. For instance, they may undervalue the costs of litigation that may have to be met by socially irresponsible corporations, while socially responsible firms may be better protected against such costs. As a result, SRI may outperform conventional funds in the long run. This outperformance hypothesis is also at odds with the efficient market hypothesis. If SRI screening processes do generate value-relevant information, conventional portfolio managers could easily replicate the screens, and the performance edge of SRI over conventional investments should then diminish.
The question as to whether SRI creates stockholder value is ultimately an empirical one. Empirical findings on the performance of SRI are mixed. Although there is little evidence that the average performance of SRI funds in the United States and the United Kingdom is different from that of conventional funds, SRI funds in many continental European and Asia-Pacific countries underperform their benchmarks.3 Existing studies hint, but do not unequivocally support, that investors are willing to accept suboptimal financial performance if their personal values on social responsibility are satisfied.
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