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The conditional performance of US mutual funds over different market regimes: do different types of ethical screens matter?

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Abstract

We investigate the performance of US mutual funds that employ different ethical criteria: religious, socially responsible, and irresponsible. Performance is evaluated over different market regimes using a Markov-switching conditional CAPM approach that endogenously defines different states of the market. This model is also extended to a multifactor context. The results show that estimates of performance vary across different market regimes. The Vice Fund, which invests in unethical firms, outperforms in low-volatility regimes, but underperforms in high-volatility regimes. These results contradict the Vice Fund’s claim that it constitutes a “solid investment during recessionary periods”. Our results show that socially responsible and morally responsible funds exhibit different performance across different market conditions, thereby supporting the use of performance evaluation models that take into account different market regimes. Overall, different types of ethical screens seem to lead to different performance patterns across different market regimes.

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Notes

  1. Although historically the first filters used in socially responsible investing were of the religious type, most current screens used by socially responsible mutual funds are of a social nature and involve issues on the current social agenda. There has been a general tendency over time for the appearance of mutual funds that employ stakeholder-oriented screens that are focused on the environment, labor practices, community relations, and the treatment of customers, minorities, and women (Waddock and Graves 2000).

  2. High levels of social performance in terms of labor relations (Waddock and Graves 1997), community relations (Waddock and Graves 2000; Simpson and Kohers 2002), and environmental issues (Klassen and McLaughlin 1996; King and Lenox 2001; Konar and Cohen 2001; Salama 2005; Derwall et al. 2005) are documented to have a positive impact on firms’ financial performance.

  3. The Vice Fund invests in activities that are considered less socially responsible, such as the defense, gaming, tobacco, and alcohol industries.

  4. As representative of sin funds, we consider the only fund that falls into this category: the Vice Fund. The comparison of two categories that are composed of multiple funds with one category that is represented by a single fund is not straightforward. An alternative would be to construct portfolios of sin stocks to represent the “sin” fund category. However, it would not be appropriate to compare the performance of actively managed funds with unmanaged portfolios. Chong et al. (2006), Shank et al. (2005), and Statman (2007) also use the Vice Fund to represent the class of socially irresponsible investing.

  5. The evidence suggests that conventional funds underperform in expansion periods and outperform in recessions periods (Moskowitz 2000; Wang 2009; Glode 2011; Kosowski 2011). Some authors argue that this finding may be explained by the fact that fund managers’ abilities are state dependent and that managers make more informed trading decisions in recessions (Glode 2011) while others argue that it may be explained by managers’ risk-shifting incentives (Wang 2009).

  6. According to the Vice Fund’s prospectus, it “seeks to select well-performing stocks of tobacco, alcohol, gaming, and weapons/defense companies because we believe that these industries tend to thrive regardless of the economy as a whole. In fact, they may have the potential to perform better when times are uncertain, leading many to view investment in ‘Vice’ industries as a solid strategy during recessionary periods” (http://www.usamutuals.com/vicefund/phil.aspx. Accessed on August 3, 2011).

  7. Aragon and Ferson (2006) provide a simple numerical example illustrating that in the presence of different market regimes the estimates of the unconditional CAPM are biased.

  8. The expressions “morally responsible funds” and “socially responsible funds” are also used in Ghoul and Karam (2007) to distinguish between funds that invest only in companies whose products are consistent with religious beliefs and those who invest on the basis of social values.

  9. During the course of this research, the Social Investment Forum (SIF) changed its name to US SIF (http://ussif.org/). Information from both the SRI Trends Reports and Mutual Fund Performance Charts provided by SIF were used to identify the funds.

  10. The funds identified as morally responsible include all seven funds analyzed by Boasson et al. (2006).

  11. Our sample includes non-surviving funds, but despite our efforts we cannot ensure that we were able to identify all non-surviving funds.

  12. The normality hypothesis is tested using the Doornik and Hansen (2008) test, as it has been shown to perform better in small samples. Nevertheless, we also tested normality with the Jarque–Bera test and the results are very similar.

  13. For the sake of brevity, results for individual fund performance estimates of MRI and SRI funds are not reported here but are available from the authors upon request.

  14. The different volatility market regimes over this shorter period are similar to those shown previously for the complete sample period.

  15. We repeated the analysis of fund performance based on the CAPM model and the four-factor model for this shorter period. The results are very similar to those obtained for the global period and thus not reported. Please note that for the shorter period there is one MRI fund for which we cannot estimate the MS-CCAPM and MS-C4FM models as it was in existence during only one market regime.

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Acknowledgments

We thank Markus M. Schmid (the editor) and an anonymous referee, as well as participants at the PFN 2010 and EFMA 2011 conferences, for valuable comments and suggestions.

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Authors and Affiliations

  1. School of Economics and Management, University of Minho, Braga, Portugal

    Nelson Areal

  2. NIPE - School of Economics and Management, University of Minho, Braga, Portugal

    Maria Céu Cortez & Florinda Silva

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  1. Nelson Areal
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  2. Maria Céu Cortez
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Correspondence to Maria Céu Cortez.

Appendix

Appendix

Table 8 List of sample funds
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Table 9 Appendix to Table 4: results for individual funds
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Table 10 Appendix to Table 5: results for individual funds
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Areal, N., Cortez, M.C. & Silva, F. The conditional performance of US mutual funds over different market regimes: do different types of ethical screens matter?. Financ Mark Portf Manag 27, 397–429 (2013). https://doi.org/10.1007/s11408-013-0218-5

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