Investing in Socially Responsible Mutual Funds
Abstract We construct optimal portfolios of mutual funds whose objectives include socially responsible investment (SRI). Comparing portfolios of these funds to those constructed from the broader fund universe reveals the cost of imposing the SRI constraint on investors seeking the highest Sharpe ratio. This SRI cost crucially depends on the investor’s views about asset pricing models and stock-picking skill by fund managers. To an investor who strongly believes in the CAPM and rules out managerial skill, that is, a market index investor, the cost of the SRI constraint is typically just a few basis points per month, measured in certainty-equivalent loss. To an investor who still disallows skill but instead believes to some degree in pricing models that associate higher returns with exposures to size, value, and momentum factors, the SRI constraint is much costlier, typically by at least 30 basis points per month. The SRI constraint imposes large costs on investors whose beliefs allow a substantial amount of fund-manager skill, that is, investors who heavily rely on individual funds’ track records to predict future performance.