...instead using an aggregate measure. While scores on composite social performance indicator are negatively related to stock returns, we find the poor financial reward offered by such firms is attributable to their good social performance on the environment and, to a lesser extent, the community aspects. Considerable abnormal returns are available from holding a portfolio of the socially least desirable stocks. These relationships between social and financial performance can be rationalized by multi-factor models for explaining the cross-sectional variation in returns, but not by industry effects.

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There are now a large and growing number of ethical mutual funds in the US, Canada, and Europe. According to the US Social Investment Forum, over 10% of all equity investment is currently managed under the guidelines for Socially Responsible Investment (SRI). SRI is related to the concept of corporate social responsibility (CSR), and the former often involves a fund implementing "ethical screens" to ensure that it does not invest in firms that have poor records in the latter. Many large mutual funds and pension funds now include ethical criteria in their stock selection processes, and there is evidence that analysts are under pressure to produce research on SRI issues. (1)

While the number of academic studies in this area has also increased substantially in recent years, no clear consensus has yet emerged concerning whether investment in socially responsible stocks or funds is favorable or detrimental to returns. From a theoretical perspective, one line of argument associated with the efficient markets hypothesis suggests the following logic concerning the merits or otherwise of SRI. At the individual firm level, under some assumptions concerning the existence of markets and well-defined property rights, an equilibrium should develop whereby engaging in expenditure on socially responsible activities that take place up to the point where its marginal profitability is zero. Socially responsible and irresponsible firm returns should be the same for given levels of risk and other firm characteristics.

At the portfolio level, however, if this argument concerning the neutrality of corporate responsibility for returns holds, then investors must be made unambiguously worse off by the screening-out process. Removing some stocks, sectors, or even whole countries on ethical grounds from the investable universe of securities will reduce portfolio efficiency. If we look at this issue from another angle, for investors who hold a well-diversified spread of assets to remain no worse off as a result of their social consciences, the remaining socially responsible firms' stocks must on average outperform their unscreened counterparts.

Finally, a third line of argument suggests that enhanced corporate social responsibility should lead to enhanced returns. Several possible reasons for this are outlined in Section III. All relate to an improvement in the firm's operating performance, which may feed through to its stock price. Hence, it is possible to justify a positive, a negative, or no relationship between a firm's social performance and its financial performance.

The European Commission (2001) defines corporate social responsibility as "a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with stakeholders on a voluntary basis." But it is important to recognise that corporate social performance (CSP) is multi-dimensional, and therefore focusing attention on the wrong aspect may yield inappropriate inferences. Enhanced CSP may lead to improved stock returns either directly through cost reductions and productivity improvements, or indirectly through an improvement in the firm's overall standing that makes analysts more willing to recommend the stock and investors more willing to hold it irrespective of the firm's costs and revenues. Thus, having a social conscience may enhance a firm's profitability by helping to satisfy its stakeholders (employees, altruistic shareholders, consumers, government). Brammer and Pavelin (2006) show that a strong CSP may enhance or damage a firm's reputation, depending upon how important that particular type of activity is to the stakeholders. A firm's level of CSR may be measured along a number of different dimensions, including philanthropic activities, reduction of adverse environmental impacts, and good treatment of employees. To our knowledge, no single study has yet examined the differential impacts of each of these aspects of CSR on stock returns.

Our research employs data at the highly desirable firm level, rather than at the fund level. It is more than possible that previous studies using data on ethically responsible funds confused corporate social performance with fund manager performance. For example, on average, socially responsible firms may yield higher stock returns than socially reprehensible firms, but that ethical fund managers are poor stock pickers, or have systematically higher costs than standard funds. To the extent that talented fund managers with strong performance records are headhunted to work for large, prestigious funds, the problem of disentangling these effects is likely to be confounded by the fact that most socially responsible funds are small. To summarize our main finding in brief, this article observes that firms scoring highly on ethical criteria appear on the surface to represent poor investments. Thus, our research lends support to the notion that findings of ethical fund underperformance may be the result of the stocks concerned, rather than bad fund managers.

The remainder of this study unfolds as follows. Section I discusses the existing evidence on the relationships between CSR and firm financial performance, while the data that we employ are described and examined in Section II. Section III presents the methodology employed while Section IV contains the results and analysis. Section V offers some concluding remarks and suggestions for further research.

I. Corporate Social Responsibility and Financial Returns: The Existing Evidence

In this section, we review the existing evidence concerning the links between corporate social responsiveness and stock market performance. It should be recognized that a significant body of work examines the link between social responsibility and accounting-based indicators of financial performance (Griffin and Mahon, 1997; Orlitzky, Schmidt, and Rynes, 2003). The literature that we review consists of three principal strands: 1) evidence at the firm level relating to assessments of firm reputation and stock performance; 2) evidence at the fund level concerning the relative performance of SRI and non-SRI funds; and 3) evidence at the firm level regarding the relationship between social performance and stock returns. We consider each strand in turn.

Several papers have investigated the relationship between a firm's degree of CSR and its reputation. For example, Antunovich and Laster (2000) employ data for the 1983-1996 period from the US survey conducted each year by Fortune magazine in producing its list of "America's Most Admired Companies." They find that the stocks of the most-admired firms yield positive abnormal returns of 3.2% in the following year and 8.3% over the following three years. The stocks of the decile of lowest-scoring firms yield negative abnormal returns of 8.6% in the succeeding nine months, although there is a sharp reversal thereafter. Chung, Eneroth, and Schneeweis (1999), on the other hand, find little evidence that highly rated firms outperform less admired firms on a risk-adjusted basis when they examine the performance of only the very highest ranked 10 firms and the very lowest ranked 10 firms.

A large number of studies have empirically examined the link between SRI and returns by examining the performance of ethical mutual funds. Guerard (1997a) finds little significant difference between the performances of socially screened versus unscreened investments. Kahn, Lekander, and Leimkuhler (1997) show that divesture of tobacco stocks would have made little difference to typical investors' returns since allocations to such stocks are usually very small. (2) In a follow-up study to his previous work, Guerard (1997b) shows that investment screens to preclude environmental or alcohol/tobacco/gambling or nuclear stocks actually yield higher average returns than unscreened investments. (3) Graves and Waddock (1994) and Cox, Brammer, and Millington (2004) suggest, using UK and US data respectively, that poor corporate social performance leads to a reduction in the number of long-term institutional investors holding the firm's stock. On the other hand, a view dating back to Rostow (1959), and Friedman (1970), is that CSR may divert resources away from projects that would have had a greater impact on profitability (see also McWilliams and Siegel, 2001).

Using more recent data for 1990-1998, Statman (2000) examines the performance of the Domini Social Index (DSI), produced by Kinder, Lydenberg, and Domini (KLD). In pure return terms, the DSI slightly outperformed the S&P 500 over the period, although risk adjustment led to a slight underperformance. Therefore, Statman's conclusion is that "pooling investing power for something other than making money is no worse at making money than pooling it for money alone" (p. 38).

Many early studies of the performance of ethical funds considered returns only and did not allow for differential levels of risk between ethical and standard funds. Hamilton, Jo, and Statman (1993) use the CAPM to examine the performance of 32 socially responsible mutual funds. They conclude that "the market does not price socially responsible characteristics" (p. 66). Using a more sophisticated multi-factor performance attribution model, Bauer, Koedijk, and Otten (2002) show that both German and US ethical funds underperform their benchmark in terms of their risk-adjusted returns, although similar UK funds achieve slight outperformance. The performances of ethical fund managers in all three countries have improved, consistent with the size and prestige of ethical funds increasing over time, enabling them to recruit increasingly talented managers. More recently, Guenster, Derwall, Bauer, and Koedijk (2005)...

NOTE: All illustrations and photos have been removed from this article.




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