A new study by Jun Duanmu and three colleagues examines hedge fund use of matters of corporate social responsibility.
The authors work from an asset-weighted composite measure of CSR by fund, in order to seek the difference in financial performance of those hedge funds with high CSR investment and those with low investment. They found no statistical difference in performance.
That doesn’t imply that CSR is useless, though. Indeed, Duanmu and colleagues found that hedge funds increased their exposure to CSR investments after the global financial crisis. This timing is a valuable clue to where its utility lies.
Lower Risk Factor Loadings
Looking at their data further, the authors found that “hedge funds with higher weighted CSR scores exhibit significantly lower risk factor loadings” than those with lower scores. CSR, then, serves as a risk mitigation tool.
Since institutional investors, including hedge funds, chiefly depend on third-party sources for CSR scores, these authors do likewise, using CSR data from the MSCI CSR Stats Database. [This was formerly known as the KLD database, because it was constructed by KLD Research and Analytics Inc.] These evaluations incorporate seven dimensions of responsibility: community, corporate governance, diversity, employee relations, environment, human rights, and product quality and safety.
But the KLD/MSCI data has limitations. Duanmu et al. say that its concerns vary from year to year, so that its data taken raw doesn’t allow for observations over time. They found it necessary to adjust this data “by constructing a scaled measure of the strengths and concerns for each dimension.” They came up with an adjusted firm level score for CSR that “is a net measure of a firm’s CSR performance in a given year where higher scores indicate better CSR performance,” and a higher score from one year to the next indicates an increase in responsible behavior in that interval.
Hedge Funds are not Mutual Funds
This paper adds to an extensive body of literature which, as the authors note, has reached mixed results as to the value of CSR. The mutual fund-centered literature, as this paper observes, “does not provide consistent evidence that fund performance is the primary driver of CSR investment.”
The authors take a hedge-fund-centered view of CSR, in part because hedge funds have notably different incentives from mutual funds. Hedge fund managers are unlikely to invest in socially responsible corporations, in contrast to low-CSR corporations, simply because they, the fund managers, want to be good citizens of the world, or because they want to increase fund flows from investors who express their own social values through their portfolios. Hedge fund managers are rewarded for performance.
Relatedly, hedge funds can’t advertise their availability to potential investors, so they would have difficulty conveying the point “we will put your money into responsible corporations” even if their goal were to attract the investors to whom that pitch would be attractive. There is even some data to the effect that hedge funds, performing their market role as arbitrageurs, are more inclined than other investors to go in the opposite direction, to buy the “sin” stocks.
However, the authors still find a net movement toward higher CSR in the hedge funds they look at since the financial crisis, and they see risk mitigation as the reason for this. Among the risks they specifically look at: idiosyncratic volatility; tail risk; the risks associated with use of the momentum factor; and the risks of betting against beta, all play a role.
The authors build on recent work concerning the betting-against-beta (BAB) anomaly. Hedge fund firms have a leverage-driven incentive to take long positions in high-beta stocks. The incentives are sufficiently great that there is an inefficiency that can be exploited by those willing to BAB, with a short position in high beta and a long position to low beta. CSR in turn may be “used to mitigate the downside risks associated with BAB.”
Duanmu is Assistant Professor of Finance at Louisiana State University’s Department of Economics and Finance. His co-authors are: Qiping Huang, Yongjia Li, and Garrett McBrayer, all Assistant Professors at Boise State University’s College of Business and Economics.