The Effect of the Business Cycle on the Performance of Socially Responsible Equity Mutual Funds

The paper applies a two-state switching regression to examine the behavior of a hypothetical portfolio of ten socially responsible equity mutual funds during the expansion and contraction phases of US business cycles between April 1991 and June 2009, based on the Carhart four-factor model, using monthly data. The information on business cycles was tracked using the dividend yield. Fund returns were less volatile during an expansion than during contraction, as indicated by the standard deviation of returns. During the contraction/trough periods, fund excess returns were explained by the differential between small and large capitalization companies (β = 0.26, p = 0.005), the difference between the returns on stocks trading at high and low book to market value (β = 0.38, p <0.0001), the market excess return over the risk-free rate (β = 0.75, p <0.0001) and fund objective (β = 0.014, p = 0.01). During the expansion/peak periods, fund excess returns were explained by fund objective (β = -0.007, p = 0.02), and the market excess return over the risk-free rate (β = 0.925, p <0.0001). The SRI investor adds a third criterion to the wealth maximization process, namely social performance, in addition to the conventional risk-return trade-off. SRI fund managers adopted a long-term investment horizon, and were prepared to sacrifice short-term returns for the psychic benefit of investing in companies with a high social performance rating. The benefit of the social performance criterion is affect, or the psychic benefit associated with the form of the investment. SRI fund managers adopted a long-term investment horizon, and were prepared to sacrifice return for the psychic benefit of investing in companies with a high social performance rating. The research suggests that the SRI investor may exhibit a risk profile unlike that of the traditional investor. The findings also suggest that excess returns earned by SRI investors are not adversely affected by the inclusion of a social performance criterion, however defined