Socially Responsible Investments – Project topics materials

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Screening Approaches

Since there is a lack of consensus of what is significant for an ethical fund, it is up to fund managers to profile themselves as ethical. In order to do so, they have to decide which companies to invest in and which ones to avoid, a selection process that is called screening. There are two broad categories for screening, namely negative and positive screening. Negative screening, sometimes referred to as exclusion, builds upon the principle to remove companies or industries from the investment universe that is involved with unethical practices. Typical factors for sector-based exclusion are attachment to weapons, tobacco, alcohol, pornography or animal testing. Another method within negative screening is norm-based screening. Through this approach, companies that violate international norms and standards are excluded from the investment universe. UN Global Compact is the most commonly used standard for norm-based screening, followed by International
Labor Organization (ILO) and OECD guidelines (Eurosif, 2014).
Positive screening is on the other hand a method where companies are included to the fund. Companies are chosen on the basis of social responsibility concerning their products, policies, performance or business activities (UN PRI, 2015). A type of positive investment screening is the best-in-class method. This method implies that companies are ranked and picked based upon their performance within the different sectors using ESG criteria.
Worth notice is that even though a company might be superior in a certain area, for example minimizing greenhouse gas emissions, they could still be involved in industries such as weapons or tobacco and yet be included into the portfolio by positive screening. Additionally, according to ENF’s basic requirements for a fund to be profiled as ethical, a maximum of 5% of the fund’s total return is allowed from the sector they claim to avoid due to negative screening (Swedish Investment Fund Association, 2012). Therefore, investors have to be aware of different screening methods in order for their investment to cooperate with their personal principles of social responsibility.
A third approach to SRI is engagement, or active ownership, where fund managers influence their holding companies though shareholder votes or other formal rights. It could also involve visiting production-facilities or attend business meetings to encourage improvement on ESG criteria. Engagement is an outstanding approach to ensure future returns, and the strategy has increased significantly in recent years worldwide (Eurosif, 2014).
As we studied the 96 ethical funds registered in Sweden, we found that the most frequently used screening approach is sector-based exclusion followed by norm-based exclusion. However, the majority of fund managers use combinations of different screening approaches in their portfolios.

Theoretical framework

Discussions about the potential trade-off between social responsibility and financial performance have circulated for years and fueled studies about ethical investments. There are two main focuses on the topic, the first one being on the firm level, also called corporate social responsibility (CSR). The other one is on the fund level, which is the focus of our thesis. The two levels are however related since a listed company that is superior in CSR is likely to be included into an ethical fund. This section is therefore presenting general theories applied to both these levels, continuing with portfolio performance theories in order to describe the drivers of risk and return. The section is followed by a review of some key previous studies and ending by deriving our hypothesis.

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The Cost-Concerned School

The very first school of thought was cost-concerned and origins hundreds of years back. The theory of neoclassical economics says that each individual is rational and will act to maximize his or hers utility or profit. The theory is built upon Adam Smith’s (1776) ‘invisible hand’, described as the force that creates market efficiency when all participants are perusing his or her own interest. Neoclassical economics implies that investors care about two factors solely: expected risk and expected return (Hickman, Teets & Kohls, 1999).
Walley and Whitehead (1994) argue that environmental performance could not be pursued without financial expenses, thus decrease financial performance. They are questioning the win-win situation while suggesting a greater focus of the “trade-off zone”, where companies value the benefits of environment concerns by taking the decreasing financial value into account. Milton Freidman (1970) stated that the only social responsibility of business is to maximize its profit, and that the responsibility is aimed towards shareholders. Further, he argues that environmental protection is not in the shareholders interest and therefore it should not be incorporated as a business goal. Ethical investments seem to be incurred with higher transaction costs and management fees due to the screening process and the need for specialized data. They will therefore generate a lower expected return for a given level of risk, relative to a conventional fund. The limited diversification effect1 might also harm ethical funds since the industries excluded though negative screening tends to be industry sectors that generally generates above-normal returns on investment (Tippet, 2001).

1 Introduction
1.1 Problem Discussion
1.2 Purpose & Delimitations
1.3 Disposition
2 Socially Responsible Investments
2.1 Market Development
2.2 Screening Approaches
3 Theoretical framework
3.1 The Cost-Concerned School
3.2 The Value-Creating School
3.3 The Modern Portfolio Theory
3.4 The Stakeholder Theory
3.5 Asset Pricing Models
3.6 Previous Research
3.6.1 Mutual Fund Performance
3.6.2 Management Fees
3.7 Hypothesis Formulation
4 Data & Method
4.1 Data
4.2 Method
5 Empirical Results
5.1 Performance
5.2 Management Fees
6 Analysis of Results
7 Conclusion
List of references