Are Investment Managers Investing Ethically at a Disadvantage

Executive Summary It is the fiduciary duty of the investment managers to maximize returns at a reasonable level of risk for their clients. The greater the number of investment opportunities, the more likely that the managers will achieve the objective of maximizing return and minimizing risk. Ethical investing involves screening out certain investments on moral grounds. Such practice would inevitably lead to the exclusions of some potentially profitable businesses and thus reduces the number of investment opportunities. The logical question one would ask is whether investment managers who follow ethical investing principle are at a disadvantage vis-a-vis other managers whose investment options are not restricted. This paper examines this issue by analyzing the performance of faith-based funds which adopt the toughest exclusionary screens. Our results show that their performances are not worse than their unrestricted counterparts. This implies that investment managers are not shortchanging their clients even though their investment choices are restricted by their ethical principles. Introduction A mutual fund is an investment company whose objective is to achieve a satisfactory level of return for their clients at a predefined risk level. Mutual fund managers have the fiduciary responsibility to serve their clients by managing the money contributed by the fund holders with prudence and market wisdom. Their investment decisions will determine the financial well-being of their clients. Investors usually put their money in funds which they believe will outperform the market or will invest in assets which are consistent with their personal values. Mutual funds that adopt socially responsible investing approach and focus on investing in companies that adhere to certain social, ethical, and environmental standards - and increasingly, to good corporate governance are known as socially responsible investment (SRI) funds. For example, many socially responsible funds refrain from investing in firms which are heavy polluters of the environment. SRI funds are a special market segment that is still relatively small but fast growing in the asset management industry. Therefore, the financial return of these funds is of great interest to investors and investment companies. In this paper, we focus exclusively on the faith-based ethical funds that employ the toughest exclusionary screens for selecting stocks in order to examine whether these funds can deliver the risk-adjusted financial performance that is in par or exceed the performance of the Standard and Poor's 500 (S&P500) and other broad market indices. Specifically, we investigate the financial risk-return characteristics of the five faith-based funds that concentrate on ethically and socially responsible investments, namely, Aquinas Value, Aquinas Growth, Aquinas Small Cap, Noah Fund, and Lutheran Brotherhood Fund. In other words, our research focuses on the question: Can these funds that employ the toughest ethical and social standards still deliver the risk-adjusted financial returns to investors that meet or exceed the performance of similarly placed funds, or broad measures of return in the financial markets, such as S&P500, and other broad market indices? Can investors make ethically and socially responsible investments based on their faith without sacrificing satisfactory financial returns? Our study period is from the inception of each of these funds to the end of year 2003. The time period spans both the bull and bear markets in the United States as well as before and after 9/11 periods. One common concern of many mutual fund performance studies is the so-called survivorship bias which results in an overestimation of the true performance regarding the universe of investment funds if funds that have been closed in the past are not included in the investigation. Our study is free of survivorship-bias as none of the funds in our study sample has closed during our study period. …