A Measure for the Diversification Trade-Off in Socially Responsible Investments
Working Paper Series on Social Responsibility, Ethics and Sustainable Business, Vol. 5 (2016)
Posted: 19 Oct 2016
Date Written: April 1, 2016
Socially responsible investing (SRI) is considered to a greater extent by investors wishing to avoid their savings being used in “unsocial” businesses. Essentially there are two main types of SRI strategy: negative screening and positive investing. The former screens out securities according to established social criteria. The latter simply advocates including companies that follow predefined social criteria in the portfolio. Both these strategies, while seeking to consider financial and societal returns, reduce the population of corporations in which to invest. Thus, financially speaking, a non-negligible drawback of SRI is that it is not possible completely to diversify the unsystematic risk of the shares in the portfolio.
Although the literature on the financial performance of SRI is copious, no one, as far as it is possible to determine, has yet dealt with the measure of the residual diversifiable risk a socially responsible portfolio bears.
This paper fills this gap. It is proposed a straightforward measure of the residual unsystematic risk that a selective portfolio investment strategy such as SRIs eventually bears. The model is empirically tested using the MSCI SRI family of indices. The study finds that a low but not negligible part of the volatility of the returns could be diversified by not restricting the investment to socially responsible companies.
The research makes several contributions. From a practical perspective, it offers a theoretically sound and easily implementable tool for measuring the diversification trade-off of SRI or other selective portfolio strategies. The results of the empirical application also call for socially responsible funds and investors to broaden the set of eligible stocks to include small and micro caps to achieve more effective diversification.
From a theoretical perspective, this paper contributes to the debate on the segmentation of the SRI market between value-driven and profit-seeking investors. The results indicate that socially responsible value-driven investors have to take into account the loss in diversification along with potential drawbacks in terms of returns. On the other hand, alpha seekers socially responsible investors must consider the diversifiable volatility embedded in their portfolios before concluding that a pure alpha has been achieved by SRI.
Keywords: Socially responsible investment, SRI, Environmental social governance, ESG, Mutual funds, Exchange traded funds, ETF, Portfolio diversification, Unsystematic risk, Specific risk, Diversifiable risk, Idiosyncratic risk
JEL Classification: G11, M14
Suggested Citation: Suggested Citation