Does sustainable investing reduce portfolio risk? A multilevel analysis

• Published date: 01 November 2021
• Author: Sylvia Maxfield,Liu Wang
• Date: 01 November 2021
• DOI: http://doi.org/10.1111/eufm.12296

Eur Financ Manag. 2021;27:959–980. wileyonlinelibrary.com/journal/eufm © 2020 John Wiley & Sons Ltd.

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DOI: 10.1111/eufm.12296

ORIGINAL ARTICLE

Does sustainable investing reduce portfolio

risk? A multilevel analysis

Sylvia Maxfield

1

|Liu Wang

2

1

Department of Management, School of

Business, Providence College, Providence,

Rhode Island, USA

2

Department of Finance, School of

Business, Providence College, Providence,

Rhode Island, USA

Correspondence

Liu Wang, Department of Finance,

School of Business, Providence College,

Providence, RI 02918, USA.

Email: lwang@providence.edu

Abstract

This study complements and extends prior research

on the risk mitigation role of sustainable investing.

We use a continuous measure of funds' sustainability

traits, rather than a categorical approach, and assess

impact on risk directly rather than by looking at fund

performance in up versus down markets. We find

that sustainable investing plays a significant role in

mitigating total, systematic, and idiosyncratic risk of

equity funds, even after controlling for other fund

characteristics. Further evidence indicates that the

explanation for the risk reduction role of sustainable

funds largely runs through traits of the firms held in

the funds.

KEYWORDS

mutual funds, portfolio risk, sustainable investing

JEL CLASSIFICATION

G11

1|INTRODUCTION

The growing popularity of sustainable investing has stimulated a large body of academic re-

search. Initiated as a value‐based investment process that primarily used exclusionary filters to

weed out exposure to certain types of companies/industries, sustainable investing has evolved

over time to include the consideration of environmental, social, and governance (ESG) impacts

and to cover a variety of positive and negative screening methods. Despite inherent differences

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We would like to thank the anonymous referee and Editor John Doukas for their valuable comments and suggestions,

which have substantially improved the quality of this paper. The authors are listed in alphabetical order.

in various approaches to investing, terms like “sustainable investing”,“socially responsible

investing (SRI)”and “ESG investing”are often used in similar or even interchangeable fashion.

In line with Morningstar, we use the term “sustainable investing”throughout the paper to best

capture the essence of both its values‐based orientation and ESG considerations.

In the literature, most research tests for statistical evidence of impact on fund performance

and, if there is statistically reliable evidence of impact, whether sustainable investing leads to

better or worse fund performance. The empirical evidence is mixed. Some studies find that

sustainable investing has a positive impact on fund performance (e.g., Derwall et al., 2005;

Kempf & Osthoff, 2007). Others indicate that sustainable funds tend to underperform con-

ventional funds (e.g., Ferruz et al., 2012; Jones et al., 2008; Renneboog et al., 2008). Numerous

studies show that there is no significant relationship between sustainable investing and fund

performance (e.g., Bauer et al., 2005,2006; Bello, 2005; Hamilton et al., 1993; Hartzmark &

Sussman, 2019; Humphrey et al., 2016; Kreander et al., 2005; Statman, 2000). These scholars

would concur with Humphrey and Tan's (2014: 376) summation that “the overwhelming evi-

dence suggests that there is no difference in the risk‐adjusted returns of SRI funds compared to

conventional funds”.

Notwithstanding almost 30 years of research, differences in research design and metho-

dology still hinder our understanding of the impact of sustainable investing. The first moti-

vation of this study, therefore, is to advance research design and more systematically investigate

the performance of sustainable funds. In the literature, a common method used in existing

studies is a paired comparison of sustainable funds and conventional funds. However, it is

precisely the challenge of categorizing sustainable funds that sceptics argue may account for the

mixed conclusions in the empirical investigation of socially responsible funds and their fi-

nancial performance. As Statman and Glushkov (2016) point out in their study, “it is impossible

to draw clear boundaries between socially responsible and conventional funds, because no clear

boundaries exist”. A promising strategy to overcome this challenge is to examine all funds “on a

continuous basis”(Kreander et al., 2005). In addition to the issues of fund categorization, the

matching approach also ignores heterogeneity within each group (El Ghoul & Karoui, 2017).

Following the suggestion of Kreander et al. (2005) and El Ghoul and Karoui (2017), we examine

all U.S. equity mutual funds “on a continuous basis”, where the Morningstar sustainability

score is utilized to measure fund sustainability. Using a novel, continuum approach across all

U.S. equity funds, our research design allows us to avoid the fund categorization debate and to

conduct a panel regression controlling for various cross‐sectional factors, such as fund size,

fund age, portfolio concentration, fund turnover, leverage, manager tenure, manager owner-

ship, and fund flows.

Among different research streams on sustainable investment and fund performance, a small

number of studies (Henke, 2016; Nofsinger & Varma, 2014) suggest a promising new direction;

this is to examine sustainable investing as a way to mitigate portfolio risk. Using a sample of 240

U.S. equity mutual funds, Nofsinger and Varma (2014) test this hypothesis and find that socially

responsible funds tend to outperform during periods of market crises and that this dampening

of downside risk comes at the cost of underperforming during non‐crisis periods. Turning from

equity funds to fixed income funds, Henke (2016) finds that socially responsible fixed income

funds outperform during bear markets, because their strong emphasis on risk mitigation makes

them avoid investing in “irresponsible”companies. The idea that sustainable investing helps

reduce fund risk in down markets is relatively new and has implications for refocusing the

debate on the performance of sustainable funds by considering sustainable investing as a

potential risk mitigation strategy in asset allocation. The second motivation of this study is to

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MAXFIELD AND WANG