Are socially responsible exchange‐traded funds paying off in performance?

• Published date: 01 March 2023
• Author: Ya Dai,Liang Guo,Steve Liu,Hongxian Zhang
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/irfi.12389

ORIGINAL ARTICLE

Are socially responsible exchange-traded funds

paying off in performance?

Ya Dai

1

| Liang Guo

2

| Steve Liu

3

| Hongxian Zhang

4

1

School of Accounting, Finance, Information

Systems, and Business Law, College of

Business, Western Carolina University,

Cullowhee, North Carolina, USA

2

Department of Accounting & Finance, Jack

H. Brown College of Business and Public

Administration, California State University,

San Bernardino, California, USA

3

Department of Finance, College of Business,

University of Rhode Island, Kingston, RI, USA

4

Department of Business and Information

Technology, Kummer College of Innovation,

Entrepreneurship, and Economic

Development, Missouri University of Science

and Technology, Rolla, Missouri, USA

Correspondence

Steve Liu, Department of Finance, College of

Business, University of Rhode Island,

Kingston, RI, USA.

Email: steve.liu@uri.edu

Abstract

This study examines the Socially Responsible (SR) exchange-

traded funds (ETFs) by comparing their risk-adjusted perfor-

mance with a matched group of conventional ETFs in the U.

S. equity market. In contrast to prior studies that focus on

actively managed mutual funds, we find that the risk-

adjusted returns of SR ETFs are significantly lower than

those of conventional ETFs during the 2005–2020 period.

Such underperformance is only observed in non-crisis

periods but not in economic crisis periods (i.e., the 2020

pandemic recession and 2008 financial turmoil). We attri-

bute the observed underperformance of SR ETFs during the

non-crisis periods to their limited diversification of

unsystematic risks resulting from various negative or posi-

tive screens employed in the funds. We also find that net

fund flows of the SR ETFs are less sensitive to past negative

performance than are conventional fund flows. Collectively,

our findings suggest that, instead of seeking wealth maximi-

zation, socially conscious investors may choose SR ETFs to

gain non-economic utility.

KEYWORDS

exchange-traded fund, fund flows, portfolio performance, socially

responsible investing

JEL CLASSIFICATION

A13, G11, G23

Received: 9 August 2021 Revised: 12 April 2022 Accepted: 29 July 2022

DOI: 10.1111/irfi.12389

© 2022 International Review of Finance Ltd.

4International Review of Finance. 2023;23:4–26.

wileyonlinelibrary.com/journal/irfi

1|INTRODUCTION

There is one and only one social responsibility of business —to use its resources and engage in activi-

ties designed to increase its profits so long as it stays within the rules of the game, which is to say,

engages in open and free competition without deception or fraud.

Friedman (1970)

Socially responsible investing, an investment strategy pursuing both social and financial objectives, has become

increasingly appealing in recent years. In general, socially responsible (SR) funds are composed of companies with

transparent business practices, environmental care and supportive employee relations. The underlying rationale is

that these social criteria are expected to increase a company's value by improving the company's social competitive-

ness and reducing the likelihood of financial penalties from ethical violations. By 2020, the total assets of socially

responsible investment in the United States have reached $17.1 trillion, and the sustainable investing industry has

grown more than 25-fold since 1995, with an annual growth rate of 14%.

1

However, the extant literature has yet to reach a consensus regarding the financial performance of socially

responsible funds. One strand of the theory argues that SR funds may not necessarily produce different expected

returns compared with conventional funds. In accordance with the capital asset pricing model (CAPM) and its

extended models, factors that are not proxying for risks should not affect an asset's expected return (Fama &

French, 1992; Lintner, 1965; Ross, 1976; Sharpe, 1964). This suggests that the ethical component embedded in a

socially responsible firm is not likely priced by the market. Bauer et al. (2005) investigate the performance of United

Kingdom, German, and United States. SRs mutual funds and find no statistical differences in performance between

SR mutual funds and conventional funds.

An alternative hypothesis argues that SR investments could decrease investors' expected returns. In this regard,

socially responsible investors are willing to receive a lower expected return as a fair exchange for doing good for

society. In other words, SR investors choose to pursue their social values by holding SR portfolios at the expense of

economic gains (Bollen, 2007). Moreover, based on the Modern Portfolio Theory (Markowitz, 1952), investing in a

constrained set of firms limits a portfolio's diversification and would lead to lower returns compared with an

unbounded diversified portfolio at a given risk level.

It is also possible that SR investments could generate higher expected returns than conventional funds—“doing

well while doing good.”Compared with conventional firms, socially responsible firms are less likely to face financial

penalties due to ethical violations. Furthermore, companies that adopt socially responsible practices are often

believed to have good business credibility, which plays a crucial role in revenue generation and market competition.

2

This will, in turn, increase a firm's growth opportunities and lead to higher expected returns for the SR portfolios.

That is to say, SR investors would gain higher expected returns by pursuing both social values and financial goals.

These theories suggest that SR funds could underperform, outperform, or perform the same as conventional

funds. Unlike prior studies that, in large part, focus on the performance of SR mutual funds, we extend this line of lit-

erature in our study by investigating the performance of U.S. SR exchange-traded funds that employ passive

investing strategies.

3

The passively investing ETF market is a more suitable laboratory because the nature of mutual

funds would limit our ability to identify the exact driving force in return variations. First, the passive scheme of ETFs

enables us to screen out the confounding effect of fund managers' selection skills in the comparison analysis. Prior

studies using SR active mutual funds are often subject to the joint hypothesis problem: the performance differences

between SR funds and non-SR funds are driven by both SR investment screening strategies and fund managers' skill

levels. Thus, the exclusive analysis of passively managed ETFs will deliver more convincing results regarding the

impacts of SR investment screening strategies on fund performance. Second, the nature of ETFs' lower turnover and

management expense, greater transparency, and higher liquidity could help us avoid possible noise introduced by

transaction costs and other market inefficiencies. Prior studies (e.g., Antoniewicz & Heinrichs, 2014; Hill et al., 2015)

documented that the ETF structure allows to externalize transaction costs and hence enables lower fees than the

DAI ET AL.5