Classifying and Measuring the Performance of Socially Responsible Mutual Funds

Abstract

This article offers a factor model for classifying socially responsible mutual funds and measuring their performance. The authors provide a factor model that consists of six factors: the four widely used factors of market, smalllarge (SMB), value-growth (HML), and momentum, and two social responsibility factors, reflecting the criteria most widely used by socially responsible funds. The first social responsibility factor is the top-bottom factor (TMB), consisting of the difference between the returns of stocks of companies ranked in the top third and the bottom third by five social responsibility criteria: employee relations, community relations, environmental protection, diversity, and products. The second is the accepted-shunned factor (AMS), consisting of the difference between the returns of stocks of companies commonly accepted by socially responsible investors and the returns of stocks of companies they commonly shun. Shunned stocks are stocks of companies in the alcohol, tobacco, gambling, firearms, military, and nuclear industries. A factor’s coefficient is its loading, tilt, or beta; the authors use the term beta. TMB and AMS factors’ betas effectively capture the social responsibility features of indices and mutual funds, and the TMB and AMS betas of indices and mutual funds generally reflect the social responsibility scores of the companies whose stocks they contain. The classification of socially responsible mutual funds by betas and contents differs from classification by Morningstar and other classifying services. Mutual funds’ measured performance when the authors consider TMB and AMS factors differs from their measured performance when these factors are overlooked. TOPICS:Performance measurement, analysis of individual factors/risk premia, factor-based models

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