Does socially responsible investment equity indexes in emerging markets pay off? Evidence from Brazil

Abstract

This paper explores the financial performance of a mainstream socially responsible investment equity index in emerging markets: the Brazilian Corporate Sustainability Index. The results indicate that investors in emerging markets could accommodate their ethical values while at the same time not scarifying their overall portfolio performance in bullish market periods. However, the financial crisis led ethical investors to take a riskier and less profitable portfolio. These results seem to be due to socially responsible investment in Brazil that, as with other emerging markets, is highly influenced by social and institutional factors.

Introduction

Demand for integrating social and environmental concerns in financial markets was supplied by the introduction of different mechanisms for socially responsible investment (SRI). This approach, also known as ethical investment or sustainable investment (Renneboog et al., 2008), considers factors related to the environment, society, and human rights, in addition to traditional financial issues, thus allowing investors to match their investment strategy with their ethical values (Domini, 2001). Although SRI emerged in the middle of the last century, it has come into prominence largely within the past two decades (Fowler and Hope, 2007). During this period, SRI has ceased to be a niche activity and has become a core factor for mainstream investors in developed countries (Statman, 2006).

As a report from EUROSIF (2010a) emphasizes, “Total SRI Assets under Management (AuM) in Europe have reached €5 trillion, as of December 31, 2009, whereas they represented close to €2.7 trillion in 2005.” In the United States, SRI has increased in terms of dollars invested by 1200% between 1995 and 2009, resulting in a current share of about 10% of the SRI assets in the AuM on that market (EUROSIF, 2010a). The great development of this non-conventional investment approach was mainly originated by demand from institutional investors, through the mainstreaming of environmental, social, and governance principles in financial services, and by external pressures from the major nongovernment organizations (NGOs) worldwide (EUROSIF, 2010a).

This steep growth in SRI worldwide has stimulated the interest of academics and practitioners in conducting research on SRI performance (Fowler and Hope, 2007). Previous studies have mainly focused on measuring the risk-adjusted returns of several SRI assets, investment or pension funds, or SRI equity indexes in developed countries (Fowler and Hope, 2007). Although emerging markets have been a mainstream research area in the management and business agenda, thus far there has been little interest in SRI performance research in emerging countries. This lack is even more remarkable when considering that, according to the International Finance Corporation's¹ (IFC) claims, investor interest in SRI in emerging markets has gained momentum over the past decade (IFC, 2011).

A global overview indicates that SRI has gradually evolved in emerging markets to represent over €200 billion² (MERCER and IFC, 2009). This increase could be explained by the integration of corporate social responsibility (CSR) principles into financial markets, which is relevant to social and economic progress in emerging countries. More importantly, another relevant factor is the development of SRI equity indexes, which are non-conventional stock indexes of great relevance in this process because they have contributed to increased awareness and growing acceptance of the core concepts of sustainable investing among both companies and investors in these countries (IFC, 2011).

The most notable example of this process is the creation and development of the Brazilian Corporate Sustainability Index (BCSI) in Brazil in 2005. As an illustration, the amount of Brazilian retail SRI AuM grew from about €42 million in 2005 to over €700 million in 2009 (MERCER and IFC, 2009). This phenomenon has been similar to what occurred in the U.S. and Europe as a consequence of the appearance of the Dow Jones Sustainability Indexes (DJSI) and the FTSE4Good Indexes. However, although the U.S. and Europe SRI equity indexes' “revolution” has been widely studied (Schröder, 2007), similar studies have not been done in emerging markets.

To address this issue, this research explores, following traditional research on corporate social performance (CSP), the financial performance of the BCSI, thus contributing to the recent claims of the IFC and the World Bank that state that more research is required to further document the possible relationship between a company's sustainability performance and financial outcomes in emerging markets (IFC, 2011). Because the companies included in the BCSI are associated with higher levels of sustainability (see Appendix 3 for further details), this research should bring new insights about how companies' sustainability policies and strategies influence their financial performance. The analysis of BCSI performance could allow for the evaluation of how Brazilian companies manage risk and avoid costs (i.e., downside risks) and take advantage of sustainability-driven innovations in products, services, brands, and other intangibles (i.e., upside opportunities) (IFC, 2011).

Although there are SRI equity indexes in other emerging countries (see Appendix 1 for a complete list of the current SRI indexes in emerging markets), the BCSI was the second launched at the global level and the first of its kind in Latin America.³ Moreover, the amount of SRI AuM in Brazil, where SRI has great institutional backing, is higher than in other emerging countries like India, where retail investors dominate. This is of special importance because institutional investors, such as pension funds, insurance companies, bank trusts, and other diversified financial forms, have become increasingly influential with their cross-border portfolios in the global financial markets in the past 20 years (Wen, 2009). Institutional investors' activism on SRI should subsequently promote global sustainability.

This study of SRI in Brazil is also relevant because that market, as with other emerging economies, presents some factors that differ from established markets and that could have a significant impact on SRI performance. Examples, among others, are the rapid population growth, the potential of companies in developing countries to lead the world in CSR practices, the limited transparency in corporate governance (CG), the great role of the government in influencing the companies' governance structures, the high levels of social and income inequalities, the restrictions of the local capital market, the limited access of the firms to long-term sources of finance, and the deficiencies of ethics management.

The analysis of the BCSI financial performance is assessed by comparing it with its official benchmark, the Bovespa Index. This is of special importance because the only difference between the BCSI and the Bovespa Index is the social and environmental screening process. Therefore, the differences between these indexes' performance could only be attributable to their different social, environmental, and corporate governance performance, aspects that will make the results more robust than those shown in other papers that use non-official benchmarks to measure the financial performance of several SRI equity indexes worldwide.

To better understand the SRI performance phenomenon in Brazil, in this study the performance of the BCSI is compared to the results obtained by the other four most important equity indexes in the Brazilian market. The empirical analysis is carried out by using econometric techniques that have not been previously applied in the SRI field. The state-space market model will allow us to identify the stochastic process that drives the time-varying return and risk levels of the BCSI. This method will make it possible to identify the appearance of regime changes in the dynamics of the BCSI risk and returns in several market conditions (i.e., bull and bear market periods alike). This is of special interest because this research examines a timeframe that covers the financial downturn in late 2008. The implemented method will also allow us to obtain results that are expected to be of special relevance for improving the asset allocation process and the portfolio management procedures in controversial economic settings in emerging markets such as Brazil. Finally, this study is focused on a recent period (2006–2010) with a large increase in SRI at the global level, even as investors have attained a significant level of knowledge about SRI equity indexes, which will make the results more reliable and relevant for discussions.

The rest of this paper is organized as follows. The next section reviews the previous literature. Open questions on this topic are reviewed and the research hypotheses are presented. Section 3 introduces the theoretical econometric models to be applied, explains the sample selection methodology, and presents a descriptive study of the data. The results are shown in Section 4. Finally, conclusions, further discussions, and future research opportunities are in the last section.