Socially responsible fund managers manage their portfolios more responsibly
One of the evils of fund management is that fund managers have a tendency to change the risks in their portfolios over time. This means that if they have a run, they tend to increase portfolio risks to increase returns. Similarly, when the end of the year is near, there is a tendency to load up on stocks that have performed well throughout the year to make the portfolio look better to investors than it really was (window dressing). The first practice means that if the hot streak of the fund manager ends, underperformance will be exacerbated due to the increased risk of the portfolio and the second practice means that naïve investors think the portfolio has done better than it actually has.
A group of researchers from Monash University in Melbourne went to see if socially responsible funds (SRI funds) are prone to the same risk shifting and window dressing exercises as conventional funds (CF). What makes their study interesting is that they not only compared SRI funds to conventional funds but also separated out the funds that are not marketed as SRI funds but have a portfolio of stocks that have high ESG ratings (High ESG CF). These are the many closeted ESG funds that I have discussed here.
The major insight here is that all funds engage in risk shifting to some extent. The volatility of the portfolio of a fund in the second half of a calendar year is higher than the volatility of the same fund in the first half of a calendar year. But at least the extent to which risks are increased is much lower for SRI funds than for conventional funds. Conventional funds, particularly those that have strong returns in the first half of the year increase risks quite aggressively in the second half, far more than conventional funds that had poor returns in the first half. The effect is even bigger for high ESG conventional funds than for other conventional funds.
Increase in volatility from the first half to the second half of a calendar year
Source: Watson et al. (2022). Note: SRI funds = Funds marketed as socially responsible funds; High ESG CF = conventional funds with a portfolio of stocks with high ESG ratings; CF = conventional funds.
But the fact is conventional fund managers with strong returns in the first half of a year increase portfolio risk more aggressively than fund managers with poor returns in the first half. SRI fund managers do not show this behaviour and thus act – in a way – more responsibly towards their investors.
When it comes to window dressing at the end of a year, all fund managers engage to some extent in the practice. But again, managers of socially responsible funds do that to a lesser degree than conventional fund managers. The chart below shows the Sharpe ratio of funds if their year-end holdings would have been held all year vs. the realised Sharpe ratio of the fund. In other words, it is a measure of how much better the portfolio looks at the end of the year compared to what investors really get. Once again conventional fund managers are dressing up their shop windows more aggressively than SRI fund managers, creating a more distorted picture of their investment prowess.
Window dressing impact on Sharpe Ratio
Source: Watson et al. (2022). Note: SRI funds = Funds marketed as socially responsible funds; High ESG CF = conventional funds with a portfolio of stocks with high ESG ratings; CF = conventional funds.