Corporate Social Responsibility
Risk and Return in Portfolio Management
Theodore Syriopoulos[*]
Department of Shipping, Trade and Transport,
University of the Aegean
Andreas Merikas
Department of Shipping Business,
University of Piraeus
Abstract:
Volatility dynamics of stock returns and portfolio management implications are investigated for a sample of companies that are major advocates of corporate social responsibility(CSR) and key members of the Greek CSR Network. The risk-return profile of selected CSR stocks and its impact on shareholder value is assessed in alternative generalized and exponential autoregressive conditional heteroscedasticitymodels. The EGARCH model takes into account asymmetric effects and is found to be an adequate and statistically satisfactory representation of CSR stock return volatility.A negative shock is anticipated to potentially cause volatility to rise more than a positive shock of the same magnitude supporting a leverage effect. TheCSR stocks showpersistent though varying volatility, indicating that asset allocation to CSR companies may not present a low risk investment opportunity.Domestic ‘market effects’ can have an impact on CSR stock behavior, but sectoral and company-specific fundamentals may alsobe important to portfolio management strategies.
JEL Classification:C32, C52, G11, G12,G32.
Keywords: corporate social responsibility;socially responsible investments;
conditional EGARCH volatility dynamics;portfolio management strategies.
Corporate Social ResponsibilityAsymmetricDynamics
in Portfolio Management Strategies
1.Introduction
The complex concept of corporate social responsibility (CSR)induces companies to explicitly consider the demands and expectations of a wide range of stakeholders in running their business. Emphasis on value creation, on the other hand, seems to imply a stronger focus on shareholders. The CSR strategy can have a feedback effect on shareholder value, since it affects production costs, revenue, cost of capital, cash flows and earnings and ultimately the company’s stock price and market capitalization(Kim and van Dam, 2003). This is an important issue for an increasing amount of investments by private and institutional investors, such as pension funds,whichis directed towards socially responsible investments (SRI).Socially responsible asset allocation promotes investments to companies that keenly promote not only their financial but also their social performance (Merikas, 2003).
From an asset management viewpoint, it is important to assess the risk-return profile of a portfolio allocated to CSRassets and evaluate its implications for efficient portfolio management strategies.The advocates of the Capital Asset Pricing Model (CAPM) maintain that (assuming market efficiency) asset allocation to CSR stocks may lead to lower returns in the long-run due to diversification costs, as CSR stocks are only part of the market portfolio (Markowitz approach). The opponents to that approach (Moskowitz approach) underline that CSR portfolios could attain higher returns relative to the market, as they integrate important information which cannot directly be conceived and evaluated accordingly by the markets (Kurtz, 1999). Recent evidence is not conclusive, though it is not supportive of the view that stock screening would damage the risk-return performance by narrowing the available investment universe.On the contrary, including CSR investments in a portfolio can reduce portfolio volatility and result in higher returns compared with a traditional investment approach (Institute of Business Ethics, 2003; Cowe, 2004).SRI is seen increasingly as an investment style but one which can add value to other styles such as value, growth, technology or emerging markets.Key issues for asset valuation and portfolio management remain whether corporate social responsibility can potentially result to higher CSR stock returns relative to the market portfolio, hence boosting shareholder value and whether investors valueCSR stocks as a low volatility ‘safe heaven’ at nervous market times.The risk profile of CSR stock investments,hence, has important implications for investors’ decisions on asset allocation to CSR securities.Despite the financial benefits identified for companies embracing CSR, the implications for CSR stock price behavior have not been uniform across all companies or sectors (Cowe, 2004).Understanding the mechanism of volatility dynamics behind different CSR stock reactions can present important investment opportunities and affect portfolio management decisions.
As further insight in these issues would be useful, this study attempts to fill some of the gaps in the topic and contribute a range of innovative conclusions. The emphasis here is placed on time-varying volatility implicationsfor CSR stock returns. The empirical findings are expected to shed some light on the feedback effect of CSR volatility on shareholder value. Despite extensive past research in volatility dynamics, there remains no general agreement as to how the predictability of volatility should be modeled more efficiently and how to condition such models for the asymmetric nature of stock return volatility (Henry, 1998). Mispecified models of stock volatility, on the other hand, may lead to incorrect or invalid conclusions about stock return dynamics. Empirical evidence has also indicated that a negative shock to stock returns can potentially generate more volatility than a positive shock of equal magnitude (e.g. Pagan and Schwert, 1990; Nelson, 1991; Engle and Ng, 1993). In case that stock prices fall due to some bad news, the weight attached to debt in the capital structure increases as the equity value of the firm decreases, resulting to higher debt-to-equity-ratio and making the firm riskier. This increase in leverage will lead equity holders, who bear the residual risk of the firm, to anticipate higher expected future return volatility (e.g. Black, 1976; Christie, 1982).To investigate these issues, alternative symmetric GARCH and asymmetric EGARCH models are specified and their validity is statistically tested to conclude whether they can adequately describe CSR stock variance dynamics (e.g. Engle, 1982; Bollerslev, 1986; Nelson, 1991; Bollerslev et al., 1992; Glosten et al., 1993; Rabemananjara and Zakoian, 1993; Sentana, 1995; Bera and Higgins, 1995). Furthermore, the majority of past studies in CSR issues have focused mainly on developed markets, predominantly the US and UK. Departing from this practice, the interest here is in the implications of CSR impact on stock behavior in a smallrecentlyupgraded European market, namely Greece. For that, a carefully selected sample of companies,sectorally well diversified, is analyzed.These companies are established members of the ‘Greek Corporate Social Responsibility Network’, well reputed to consistently promote CSR strategies, leaders in their business fields and their (blue chip) equities aretraded in the Athens Stock Exchange (ASE).In the next section,recent trends in CSR and SRI are summarized. Section 3 presents both symmetric and asymmetric CSR stock volatility models. Section 4 analyzes the empirical findings and the final section concludes.
2.Recent Trends in CSR and SRI
The recent trends in CSR and SRI are seen to move upwards at a robust pace.Social responsible investmentsrepresent approximatelyUSD 3 trillion at a world level,with 67% originating from the US, 25% from the UK, 5% from France and the rest from other developed countries, such asCanada and Australia (Merikas, 2003). In the leading US market, one out of eight dollars invested in the States was part of a socially responsible portfolio in 1999and SRI growth rates were twice as high those of conventional investments. Thisresulted to SRI increasing to USD 2,32 trillion in 2001 from USD 639 billion in 1995 and USD 40 billion in 1984.Similarly, US socially responsible mutual funds increased to 181 funds with approximately USD 2,010 billionunder management in 2001 (Social Investment Forum, 2003). Of the three major SRI strategies, that is investment screening, shareholder activism and community investments, investment screening exhibitscomparatively stronger growth rates(Table 1).
Table 1: Social Responsible Investments*Investment Strategy / 1997 / 1999 / 2001 / Δ (%) / Δ (%) / Δ(%)
(1) / (2) / (3) / (2) / (1) / (3) / (2) / (3) / (1)
Investment Screening / 529 / 1,497 / 2,010 / 183% / 35% / 280%
Shareholder Activism / 736 / 922 / 897 / 25% / -3% / 22%
CommunityInvestments / 4 / 5,4 / 7,6 / 35% / 41% / 90%
Invest. Screen. & Shar. Activism** / (84) / (265) / (592) / 215% / 123% / 605%
Total Investments / 1,185 / 2,159 / 2,323 / 82% / 7% / 96%
*US billion; ** in order to avoid double-counting, funds that employ both investment screening and shareholder
activism strategies are subtracted from total investments.
The UK market has also seen strong CSR investment trends and SRI funds rose twenty-fold, from USD 353 million in 1989 to USD 7,138 million in 2000 (UK Social Investment Forum, 2002).Following a recent market research by the UK Social Investment Forum in a sample of 600 top British pension funds, 59% of assets under management incorporate social responsible criteria in their investment strategies. In Germany, total investments in CSR stocks and funds surged from USD 366 million in 1998 up to USD 2,9 billion in 2001 (0.7% of total market); projections estimate a 10% market share in SRI funds by 2010.In the EU, anoverall amount of USD 17,5billion was invested in 220 social responsible funds by end-2000, a considerably low market share (Merikas, 2003).
Past empirical research investigating the performance of CSR investments has most frequently focused on SRI mutual funds. Conclusions, however, havebeen rather ambiguous and contradictory. The larger share of socially responsible investments, predominantly in the US and UK, has been channeled via specialized SRI mutual funds,which exhibitupward growth trends as alternative investment vehicles. Hamilton et al. (1993) and Statman (2000) compared the SRI fund performance against conventional funds and theS&P500 and Domini Social Indices (DSI)but did not conclude any statistically significant difference in their returns. Goldreyer and Diltz (1999) employed an extensive sample of equity, bond and balanced mutual funds and found that social equity screening did not affect investment returns in SRI funds in any systematic way. However, Luck (1999) indicated that social stock selection in the DS Index has a positive impact on DSI excess returns compared to conventional stock indices.Diltz (1995), Russo and Fouts (1998) and King and Lenox (2000) concluded positive correlation between excess returns and responsible environmental corporate behavior.DiBartolomeo (1996) and Kurtz (1999), however, postulated that any excess returns of SRI fundsare related to higher implicit risk.Luther et al. (1992) compared the performance of fifteen UKSRI funds against FTSE Incides and reported weak SRI excess returns. Gregory et al. (1997), however, did not find any statistically significant impact between UKSRI and non-SRI mutual funds. At a portfolio level, Woodall (1986) investigated fourty categories of CSR criteria and concluded limited return losses, whereas Kahn et al. (1997)and Guerard (1997) found that social stock screening can lead to higher returns. At a company level, Klassen and McLaughlin (1996), Gunthorpe (1997) and Hall and Rieck (1998) indicated a positive (negative) impact of good (bad) corporate environmental announcements and company stock returns. Feldman et al. (1997) estimated a 5% potential stock return increase in companies that improve their environmental policies andWaddock and Graves (1997) concluded a positive impact between management quality, employment policies and shareholder value (Merikas, 2003).
A number of comparative studies in risk and return ofCSR investments indicated that no exceptional differences were found between SRI and non-SRI mutual fund returns.The Ethical Investment Research Service (EIRIS, 1999), for instance,examined the performance of five CSR stock indicesrelative to a conventional market index, the FTSE-All Share Index[1]. It was concluded that CSR and FTSE index returns were similar, whereas volatility in three out of five CSR indices was lower; hence, a CSR investment can support risk diversification and portfolio hedging. The Sustainable Investment Research International Group (SIRI, 2003)conducted a studyin a number of mutual funds that applysocial stock screening strategiesand compared their risk and return profiles with the respective conventional peer fund group[2]. It was concluded that CSRmutual funds can potentially produce a return performance competitive to conventional mutual funds, which though may be associated with a relatively higher level of risk (Merikas, 2003).
The Greek market followsthe major CSR trends seen in Europebut CSR investments remain at a particularly low level (Merikas, 2003). The establishment of the ‘Greek Network for Corporate Social Responsibility’, however,underlines the increasing domestic corporate interest in the subject. The Greek CSR Network, based in Athens, was formed in June 2000 as a non-profit organization by thirteen companies and three business institutions. It is run by a board of seven member companies and is the national partner of the European CSR Network, established in 1996. The Greek CSR Network mission is to promote the meaning of CSR to both Greek businesses and Greek society with endmost target a balanced achievement of profitability and sustainable development. The Network aims at recording and publicising Greek companies' best practice in corporate social responsibility;collecting new data concerning Greek companies and corporate social responsibility; raising companies' awareness of corporate social responsibility and supporting their understanding and development of it; developing the public's awareness and perception of companies' CSR activity; networking and collaborating with companies and organizations on all levels for the exchange and spread of information; enrolment of new members to the Network (HNCSR, 2004).Recently, the Greek CSR Network has been promoting social responsibility for small and medium-sized enterprises at a range of conferences, presentations and business institutions and through CSR award committees. The Network has taken part in two projects under a European Unioninitiative that promotes equality in employment (EQUAL), focusing onthe employability of people with disabilities and immigrants.As of today, 56 companies and business institutions are members of the Greek CSR Network(Table 2).
Table 2The Greek Corporate Social Responsibility Network
BP Hellas S.A. / Hellenic Airspace Industry S.A.
Shell Hellas S.A. / Toyota Hellas S.A.
IBM Hellas S.A. / FAGE Dairy Industry S.A.
Nestle HellasS.A. / Q-PlanS.A.
Philip Morris Hellas S.A. / Agricultural Industries A. Michailidis S.A.
Janssen-Cilag Pharmaceutical SACI / Leaf Tobacco A. Michailides S.A.
Procter & Gamble Hellas Ltd. / Ziridis SchoolsS.A.
Johnson & Johnson S.A. / Clotefi S.A.
C & C International S.A. / TUV Hellas S.A.
TVX Hellas S.A. / Dimiourgiki S.A.
Vodafone-PanafonS.A.* / Cocomat S.A.
Novartis Hellas S.A. / Amacon Management Consultants S.A.
Hellenic Telecom Organization S.A.* / Interbeton S.A.
EFG Eurobank Ergasias S.A.* / PriceWaterhouseCoopers S.A.
Titan Cement Co. S.A.* / Manpower Team S.A.
Coca-Cola Hellas S.A.* / Reputation Management S.A.
Coca-Cola HBC S.A.* / EQI Engineering and Quality Consultants International S.A.
Delta Holding S.A.* / Alpha-Mentor Consultants Ltd.
Silver & Barite Ores Mining Co. S.A.* / TradeLink Reputation Management S.A.
Intracom S.A.* / Bureau Veritas S.A.
Bank of Cyprus S.A.* / Epikinonia Business Communications Network
Heracles General Cement Co. S.A.* / Federation of Greek Industries
Chipita International S.A.* / Athens Chamber of Commerce and Industry
Motor Oil S.A.* / Hellenic Organization of Standardization S.A.
Klonatex Group S.A.* / Hellenic Association of Pharmaceutical Companies
Fanco S.A.* / Federation of Industries of Northern Greece
FHL H.Kyriakidis S.A.* / Institute of Social Innovation Ltd.
Atlantic S.A.* / Hellenic Organization of Small and Medium Enterprises & Handicraft
* Listed in the ASE; Source: Hellenic CSR Network,
3.ModelingCSR Stock Return Volatility
Assume rit is the continuously compounded rate of return on CSR istock over a single period from time t-1 to t andXt-1is the information set available to investors at t-1, when the investment decision is made. The expected return and volatility of returns subject to this constraint are the conditional mean and variance of rit given Xt-1, denoted as rit = E{rit | Xt-1= xt} = b xtand hit = Var(rit | Xt-1= xt) respectively. Hence, rit = b xt + εit and the unexpected return at time t is εit = rit - E { rit | Xt = xt } = rit - b xt. The heteroscedasticity function hit is now a function of ε2it-1, …, ε2it-q. The term εitcan be treated as a collective measure of newson the i CSR stock (Engle and Ng, 1993). An unexpected increase in returns (εit0) indicates the arrival of ‘good’ news, while εit0 indicates ‘bad’ news. A large magnitude of |εit | indicates important news since it will reflect a significant change ofistock price.
Since animportant issue tostudy is whether a convenient GARCH model structure can adequately describe CSR stock return volatility, alternative symmetric GARCH and asymmetric EGARCH specifications are employed and their validity is statistically tested.The identification of conditional heteroscedasticity is equivalent to identifying an ARCH(p,q) process in the error term sequence, thus, the innovations εitare studied in details. The sample variance for a number of observations T ishi= ε2it / T
The Generalized ARCH (GARCH) models (Bollerslev, 1986) encompass the ARCH models (Engle, 1982).The GARCH modelspecifies the conditional variance, hit, as a distributed lag over past squared innovations ε2it-i, andconditional variances hit-j,ensuring non-negativity of the coefficients on the conditional variance equation:
hit = ω + αi ε2it-i + βj hit-j (2)
where ω > 0, α1, …, αp 0, β1, …, βq 0 are constant parameters (ε2it-i,the ARCH effect and hit-j, the GARCH effect). In a GARCH(p,q) model the effect of a shock to volatility declines geometrically over time. The size of the parameters α and β determine the short run dynamics of the resulting istock return volatility. The coefficientsα measure the extent to which volatility shocks today feed through into next period’s volatility.Large coefficients α mean that volatility reacts quite intensively to market movements. Large coefficients β indicate that shocks to conditional variance take a long time to die out, thus volatility is persistent.The (αi + βj) term measures the rate at which this effect dies out over time.In caseα(reaction coefficient) is relatively high and β(persistence coefficient) is relatively low then volatility tends to be more ‘spiky’.
The GARCH model imposes symmetry on the conditional variance structure whichthough may not be appropriate for modeling and forecasting CSR stock return volatility.As an alternative model, the exponential GARCH (EGARCH) specification is employed (Nelson, 1991), which allows for asymmetric or leverage effects;negative and positive shocks can have different impact on volatility. Under the EGARCH(1,1) the conditional variance is given by: