Socially responsible investment (SRI)
As socially responsible investment (SRI) has become an increasingly popular practice for investors in developed economies, a growing number of studies have investigated the financial performance of SRI indices based on these markets. For example, some studies have examined the financial performance of firms listed in the Domini 400 Social Index (DSI) in the U.S. (e.g., Sauer 1997; Statman 2000; McWilliams and Siegel 2000; Ramchander et al. 2012); others have investigated financial performance based on SRI indices such as the FTSE4Good UK 50 Index (Curran and Moran 2007; Clacher and Hagendorff 2012; Russo and Mariani 2013), the DJ STOXX 600 Index in Europe (Oberndorfer et.al. 2013), SAM’s selection of socially responsible bonds in Zurich (Menz 2010), and Morningstar in Japan (Nakai et al. 2013).
In general, these studies have not found significantly higher returns of inclusion in an SRI index, compared to non-restrictive investment in the early years after the SRI index was first announced (e.g., Sauer 1997; Statman 2000; Curran and Moran 2007; Nakai et al. 2013). Positive returns were found to be significant only quite a few years after the launch of the index (e.g., from the inception of the Domini 400 Social Index in 1990 to 2007 in Ramchander et al. 2012; from the inception of the FTSE4Good UK 50 Index in July 2001 to March 2008 in Clacher and Hagendorff 2012), and only for well-known SRI indices. For example, when Oberndorfer et al. (2013) compared the effect of German corporations’ inclusion in a newly launched SRI index (the Dow Jones STOXX Sustainability Index, launched in 2001) with that of a well-known SRI index (the Dow Jones Sustainability World Index, launched in 1999), they found that abnormal returns were significantly positive for those firms included in the well-known index, but insignificant for those in the newly launched SRI index between 1999 to 2002.
As suggested in these studies, investors are either unaware of the existence of SRI indices or do not fully understand how these listed firms perform when an SRI index is new to them (Oberndorfer et al. 2013; Nakai et al. 2013). Investors are concerned about whether they can gain any significantly higher returns by using social criteria to limit their investment universe, as doing so may result in increased volatility, reduced diversification, additional costs of screening and monitoring, and thus lower returns (Sauer 1997).
Financial performance of SRIs in emerging markets
Intuitively, one could expect that investors in emerging markets may not respond to the launch of an SRI index, a result found in past literature, because the concept is also new to emerging-market investors. However, since emerging markets represent a transitional economic development stage that differs from developed economies profoundly, the announcement of an SRI index may create positive abnormal returns to firms included in the index when the index is first released in emerging markets.
Specifically, we suggest that investors in emerging markets differ from their counterparts in developed markets in three aspects: (1) the level of uncertainties involved in their investment selection of CSR firms, (2) the incentive to apply CSR criteria in their investment selection, and (3) the level of investment experience in stock markets. These fundamental differences increases the awareness and the strength of the announcement of an SRI index and in turn lead to strong signaling effects on emerging-market investors.
First, investors in emerging markets face a much higher level of information asymmetry and uncertainties in their selection of CSR firms. This is due to a lack of strong regulation and sufficient information disclosure of firms’ CSR engagement in emerging markets. For example, because of weak regulations in emerging markets, it is unclear to many emerging-market firms what social responsibility exactly constitutes, how they should regularly report their CSR activities (i.e., which measurements and evaluations), and how they are regulated with regard to unlawful conduct (e.g., Krishna 1992; CSM 2001; Mishra and Suar 2010). Even if firms issue CSR reports, different firms focus on different aspects of CSR, which makes it challenging for investors to compare and evaluate which firms are the top CSR performers. Furthermore, compared to developed markets, where many organizations provide comprehensive and publically available data sources for investors to retrieve firms’ CSR reports, it is still difficult for emerging-market investors to find such information sources and compare them across different firms. As CNBC noticed, it is difficult to implement socially responsible investment in emerging markets, as only a handful of funds are now available to investors who want to follow these criteria and invest in developing market economics (CNBC.com, December 30, 2013).
In regard to evaluating the financial performance of CSR firms, there is also an information problem for investors in emerging markets. As the Wall Street Journal reported, financial disclosure in emerging markets tends not to be as reliable as in developed markets, which makes it difficult to discern which companies are socially responsible (WSJ, Jan. 11, 2011). Such an information problem is accentuated due to weak CSR regulation in these markets, which further intensifies the information asymmetry between investors and CSR firms in emerging markets.
Second, investors in emerging markets have a stronger incentive to apply social criteria in their investments. With rapid economic development in past decades, many emerging markets are experiencing growing environmental and social issues such as severe air pollution, rising income inequality, increasing numbers of product recalls, deteriorating environmental pollution, urgent needs related to healthcare and medical system reform, insufficiency of the social security system, and political corruption, among others. These grave environmental and social issues are thus leading shareholders to pay increasing attention to firms’ social responsibility. As a result, investors may use their investment selections to force firms to fulfill their social responsibilities.
Third, since the stock markets in emerging countries are still in their early stages, investors in these markets are lack of experiences to make investment decisions based on a full evaluation of all stocks’ financial performance on their own. Rather, a majority of them still rely on certain credible signals or follow peers’ investment selections when making their own investment decisions. Hence, when the initial SRI index is launched in emerging markets, the announcement of the index may draw special attentions from investors who have stronger incentives to apply social criteria in their investment selection but are lack of experiences in making selections on their own. Signaling theory suggests that the higher awareness a signal (i.e., the announcement of an SRI index) has drawn and the stronger reliance emerging-market investors are on the signal (due to lack of investment experiences), the stronger signaling effect a new piece of information can create (Gulati and Higgins 2003; Higgins and Gulati 2006; Connelly et al. 2011).
Moreover, because the stock exchange company or the government can gather more information that is not accessible to outsiders such as investors, the SRI index provides additional credible information to investors, thereby helping them to reduce the information asymmetry and resolve their uncertainty regarding which firms are top CSR performers. According to signaling theory, the strength of a signal may change for different institutional environments. When institutional environment lacks high-quality information needed to differentiate one firm from another, relevant stakeholders must search for additional information to assess firm capability (Su et al. 2016). Thus, when an SRI index is announced, stakeholders might have stronger incentive to use this additional information which may help reduce their uncertainty to a larger extent. In other words, the higher uncertainties that emerging-market investors are in face of, the stronger signaling effects the announcement of an SRI index can create (Spence 1973; Kirmani and Rao 2000).
Lastly, the SRI index may also help lessen investors’ uncertainty regarding the financial performance of CSR firms. According to the screening process of the SRI index,Footnote 4 investors may understand that firms listed in the SRI index have established not only outstanding performance in CSR, but also stable performance in the stock market. Even if investors are unclear about how the SRI index is constituted, they may infer from the index that the top performing CSR firms tend to have good management, and thus experience better financial performance (Waddock and Graves 1997). For example, as suggested in Sauer (1997), environmentally responsive firms are less likely to be subjected to environmental fines and lawsuits; product-responsive firms are less likely to encounter product recalls, and hence avoid costly settlements; and good corporate citizenship firms are more likely to create solid firm loyalty, which improves production efficiency, enhances creativity, and reduces production costs. Furthermore, sustaining good citizenship helps firms garner support from the government and the local community (Mishra and Suar 2010; Waddock and Graves 1997; Vidaver-Cohen and Altma 2000), which could further enhance the firm’s competitive advantage and lead to better financial performance. In emerging markets, such benefits can be significantly higher due to the growing social and environmental issues and weak regulations. These benefits can lead to higher employee and customer loyalty, and in turn higher brand recognition, as well as increased sales and revenues.
Overall, because of the three unique characteristics of investors in emerging markets, the announcement of an SRI index can create strong signaling effects on stock markets, leading to positive abnormal returns accrued to firms included in the index. Thus, we propose the following hypothesis concerning the positive effect of the SRI index announcement in emerging markets.
The announcement of an SRI index creates positive abnormal stock returns for firms listed in the SRI index of emerging markets.
Moderating role of advertising and R&D
Advertising and R&D are two important marketing strategies that could potentially enhance or undermine the financial benefits of firms listed in the SRI index. Given the three unique characteristics of investors in emerging markets, it is crucial to understand how investors in these markets respond to the announcement of the SRI index for firms with different levels of advertising and R&D expenditures. For example, do investors respond more or less positively if the listed firms invest a large amount of money in advertising or R&D? Understanding the interactions between marketing and CSR investments can help emerging-market firms effectively allocate resources to the most impactful strategy in value creation and appropriation.
Moderating role of advertising
Based on CSR measures in the U.S. (i.e., the KLD database constructed by Kinder, Lydenberg and Domini Research and Analytics, Inc.), a recent study has documented that advertising investments complement CSR investment such that firms with large advertising expenditures can achieve higher financial returns from their CSR investments in the long run (Servaes and Tamayo 2013). This study argues that the lack of customers’ awareness about a firm’s CSR initiatives is a major problem, which handicaps consumers’ ability to respond to CSR initiatives. Through large investments in advertising, firms can popularize their CSR programs and can enhance investors’ awareness of their CSR contributions to society. As a result, investors are more likely to purchase stocks from these socially responsible firms, which strengthens the financial returns of the firms’ CSR investment.
Different from Servaes and Tamayo (2013), who studied the long-term effects of CSR activities for firms with different advertising expenditures, we examine the immediate stock market responses to the SRI index announcement for firms with different advertising expenditures, where new information released from a signal can play a major role in the effect. Specifically, the larger the advertising expenditure, the more likely investors become more well-informed about the firms’ CSR activities prior to the announcement of the SRI index. At the time when the SRI index is announced, the new information that investors can obtain become much less, which weakens the effect of the SRI index announcement. This suggests a substitutive relationship between advertising spending and the announcement of the SRI index.
More importantly, in emerging markets where regulations on faulty claims or deceptive advertising are substantially weak, and investors lack trust in firms’ advertising, a firm’s larger advertising expenditures may make investors more skeptical regarding whether the firm is truly socially responsible, which could potentially weaken the credibility of an SRI index and in turn the signaling effect of the SRI index announcement.
Corporations have long been criticized for their motives in carrying out CSR. For example, Williams (1986) has voiced concerns that CSR “is a strategy for selling, not for making a contribution to society.” The in-depth interviews conducted by Webb and Mohr (1998) revealed that approximately half of the respondents believed that firms engaged in cause-related marketing campaigns to achieve firm-related gains (e.g., increasing sales and profits, garnering positive publicity). According to attribution theory (e.g., Heider 1958; Kelley 1967; Jones et al. 1972), people may attribute firms’ CSR investments for extrinsic purposes (i.e., egoistic motives of improving the corporate or brand image). Attribution theory also suggests that the degree to which people are certain that the attribution is correct is a function of the relationship between the observed effect/behavior and the perceived cause (Settle and Golden 1974). In the context of CSR, the certainty of stakeholders’ attributions regarding firms’ motives for carrying out CSR can be reinforced or rejected by what they observe—for example, firms’ marketing expenditures. A recent review study in CSR has also suggested that how stakeholders respond to a firm’s CSR initiatives may depend on whether they perceive a fit between the CSR initiatives and the firm’s marketing strategies (Bhattacharya and Sen 2004).
If investors observe excessive advertising expenditures by corporations in the SRI index, they may question whether such corporations are really driven by the maximization of all stakeholders’ benefits (including the corporation itself, consumers, and the society), or whether they are driven only by maximization of the corporations’ profits. Different from CSR initiatives that place top priority on benefitting society, advertising expenditures place top priority on benefitting corporations (i.e., corporate reputation and profits), which may not benefit society. Such a discrepancy between investments in CSR and large advertising expenditures may lead stakeholders to interpret the motivations of corporations’ CSR as extrinsic rather intrinsic; hence, they may develop negative perceptions about the corporations’ CSR actions. Extant studies have also argued this notion in a similar vein when studying the moderating role of advertising in other marketing strategic levers (Mizik and Jacobson 2003) or in firms’ financial idiosyncratic risk (e.g., Luo and Bhattacharya 2009). They suggested that because advertising is more related to the process of value appropriation (i.e., extracting value in the marketplace from customers/rivals), as opposed to value creation, investors may interpret firms’ CSR activities as being primarily for self-serving purposes rather than for social benefits when they observe that those included firms spend a large amount of money on advertising (to extract value by shifting value from other places).
As a result, such inconsistency between two signals from firms’ investment in advertising and in CSR can weaken the signaling effect of the SRI index announcement. Hence, we propose a hypothesis concerning the negative moderating effect of advertising expenditures on the financial benefits of SRI inclusion.
For firms listed in an SRI index, advertising expenditures weaken the positive impact of the SRI index on their abnormal stock returns in emerging economies.
Moderating role of R&D
Based on CSR measures in the U.S., two recent studies have also examined the moderating effect of R&D on the long-term financial returns of CSR investment, but have demonstrated contradictory findings (Luo and Bhattacharya 2006; Hull and Rothenberg 2008). Specifically, the former showed a complementary effect of R&D on the financial returns of CSR investment (Luo and Bhattacharya 2006), while the latter revealed a substitution effect (Hull and Rothenberg 2008). Luo and Bhattacharya (2006) argue for the complementary effect between CSR and R&D investments based on attribution theory, suggesting that an organization is regarded as legitimate when it satisfies and upholds both the social and pragmatic aspects of legitimacy. It is less likely that a company can generate a favorable impact from its CSR initiatives if it fails to innovate or offer quality products (i.e., the pragmatic aspect of legitimation). Hull and Rothenberg (2008), on the other hand, focus on the differentiation benefits that companies can achieve by investing in either CSR or R&D, contending that companies with the best new products can differentiate from their competitors through their product offerings and need fewer incentives to attract customers. Less innovative companies, on the other hand, require other aspects to differentiate them from their competitors, and thus can boost their financial performance by improving their CSR performance.
However, since our research differs from these two prior studies by focusing on the immediate stock market responses to an SRI announcement, the central issue in our study involves how investors interpret the announcement of the SRI index if they can observe how much the listed firms have invested in R&D. Compared to the advertising expenditure which is relatively more accessible to investors, R&D spending is an internal decision, which is often relatively less accessible to investors. Hence, although R&D expenditure can also serve as a signal indicating whether a firm is socially responsible, which could potentially substitute the signaling effect of the SRI index announcement, we suggest that such a substitutive relationship between R&D expenditure and the announcement of the SRI index tends to be weaker due to the low accessibility of R&D information to investors.
Moreover, prior spending in R&D can also serve as a legitimacy cue about how truthful the listed firms are in terms of social responsibility and in turn strengthen the credibility of the SRI index. If a low-level R&D investment firm engages in CSR activities, as suggested in Luo and Bhattacharya (2006), consumers may consider CSR investment at the expense of R&D investment; thus, they may question the motive of the firm carrying out the CSR. On the contrary, a large investment in R&D may help generate favorable attributions regarding the firm’s motivation to carry out CSR investments (i.e., intrinsic motive), because higher R&D expenditures result in higher innovation and higher-quality products. Accordingly, it helps create increased customer satisfaction and loyalty and thus leads to a generally positive perception that stakeholders have in regard to the firm’s social responsibility and better financial performance. In other words, because R&D is related more to a value-creation process, the firm’s commitment to R&D is often positively perceived as a socially responsible strategy (Mizik and Jacobson 2003).
In sum, in emerging markets where investors are more skeptical, a high level of R&D investment reinforces the credibility of the SRI index and hence strengthens the signaling effect of an SRI index announcement on stock returns.
For firms listed in an SRI index, R&D expenditures strengthen the positive impact of the SRI index on their abnormal stock returns in emerging economies.
Moderating role of global expansion
Accompanying the rise of emerging markets, firms from these markets have begun to globalize by expanding abroad, acquiring and forming alliances with global marketers to acquire raw materials, gain new technologies, and access new markets (The Economist, Sept. 18, 2008; BCG 2009; McKinsey Quarterly2015).Footnote 5 Given that this emerging globalization trend has not only attracted attention from multinationals in developed countries, but also from those in their home countries, do investors in emerging markets perceive higher financial value for globalized firms in an SRI index than for domestic firms when the index is announced? Does such a moderating effect vary with the direction of global expansion (i.e., expansion to developed markets vs. developing markets)? Although extant studies have examined whether CSR investment or globalization can generate favorable financial returns, it is less certain as to how globalization complements or substitutes CSR investments, and if such a moderating relationship varies with the direction of global expansion.
We expect that investors will respond less positively to the announcement of an SRI index for listed firms that have expanded globally to developed countries than those that have expanded to developing countries. According to signaling theory, the signaling effect would be weaker when investors have lower uncertainty about firms’ CSR activities. In the context of an SRI index announcement, investors would not be very surprised if those firms (that have expanded globally to developed countries) are included in the index. This is because these firms are expected to maintain global CSR standards when doing business in developed countries, as the CSR concept and practices have been well developed in Western countries, and the CSR standard has also evolved to a much higher/stricter standard regarding firms’ conduct in CSR than that in emerging markets (e.g., stricter requirements in pollution control, higher standards in product quality and employee benefits, etc.). Investors understand that firms doing business in developed countries must have adopted CSR requirements in these markets. Doing business in developed countries can also impose higher costs of disseminating untruthful CSR reports. Hence, when the SRI index is announced, because investors face lower uncertainty regarding the CSR performance of those firms that have expanded globally to developed countries, the signaling effect of the SRI index announcement tends to be weaker.
However, investors may have higher uncertainty regarding if and how firms have implemented any CSR initiatives when they expand to less developed countries. In many developing countries, where economic development is still the central goal, local governments focus more on economic contributions from foreign investments rather than their CSR fulfillment. Similarly, regulations are also weak in many less developed markets with respect to CSR enforcement on pollution control, product quality control, and social benefits. Thus, when investors are aware of those firms that have done better in CSR when they expand to developing countries, investors may become more likely to reward these firms by investing in them. As a result, firms that have expanded to developing countries tend to benefit more from being listed in the index than those that have expanded to developed countries.
Furthermore, investors may also have higher uncertainty regarding the financial performance of CSR firms that have expanded to developing countries. Compared to the stable and transparent business environment in developed countries, the political and economic environment in many developing countries is volatile and ambiguous. Firms may encounter much more difficulties in doing business there and hence may experience fluctuating financial returns from their investments in developing countries. When investors see these firms in the SRI index, they may become more confident about the potential benefits from investing in these firms. Overall, due to higher levels of uncertainties about firms that have expanded to developing countries, the announcement of an SRI index can create higher financial returns for these global firms than their counterparts that have expanded to developed countries. Hence, we propose the following hypotheses regarding the moderating role of global expansion when considering the direction of expansion to developed versus developing countries.
The announcement of an SRI index in emerging markets creates higher abnormal returns for those listed firms that have expanded globally to developing countries than those that have expanded globally to developed countries.