The Park Place Economist / vol. The Park Place Economist / vol. The Park Place Economist / vol. The Park Place Economist / vol. The Park Place Economist / vol. VII21The Opportunity Cost of Monetary Conviction:A Comparison of the DSI and the S&P 500I. INTRODUCTIONOf the numerous types of mutual funds thathave developed in the past decade, few have grownas fast or received as much attention as sociallyresponsible funds. SRI’s (short for sociallyresponsible investments) are funds that allow theinvestor to consolidate his or her ethical and moralconvictions with their financial goals. This newwave of “putting your money where your mouthis” allows one to purchase stocks that supportbusinesses which produce jobs, support fair trade,strengthen communities, guard the environment andspurn unhealthy practices (alcohol and tobacco).Morningstar reports that total assets in SRI mutualfunds have doubled over the last two years with thenumber of SRI funds now approaching 50, up fromjust 15 in 1991. The industry itself has grown froma $40 billion to a $639 billion industry with almostone in every ten U.S. dollars invested in such funds.(Perryman)SRI funds subject their investment universeto a series of social and financial screens that ensurethe portfolio is consistent with the consumers’personal belief system. These screens can benegative, positive or activist. Although admirablefrom an ethical standpoint, the financial viabilityand performance of such funds is questionable; basicfinancial theory espouses that a limited investmentuniverse equates with limited returns. Sociallyresponsible investors should, therefore, expect totake a loss for their monetary conviction. On theother hand, a growing pool of theory maintains thatsocially responsible investing could be morelucrative than traditional investing due to marketinefficiencies and the strength of the underlyingfirms. Hence, the purpose of this paper is todetermine whether socially responsible investorstake a loss for their monetary convictions bydelineating the theory between these two opposinghypotheses and determining which has morestatistical validity.A. Pro-Market Theories vs. Pro-SRI TheoriesThe first set of theories (called pro-markettheories) are based on the widely accepted principalsof basic finance and support the hypothesis that thegeneral market should out-perform sociallyresponsible investment funds. The second set oftheories (dubbed pro-SRI theories) support thehypothesis that Socially Responsible Investmentsshould theoretically produce greater returns than thegeneral market. The remainder of this paper willreview these two sets of theories, examine similarstudies from the recent past and then present themechanics of the current research along with theresearch findings. The final section will offer a briefconclusion and suggestions for future research.B. Brief History of Socially ResponsibleInvestingAs early back as the 1920’s, religiousorganizations and church groups prohibitedinvestment into what they considered “sin stocks,”or stocks in the liquor, tobacco and gamblingindustries. One of the first “sin screened” funds wasthe Pioneer Fund in Boston which eliminated allinvestments into alcohol, tobacco and gamblingcompanies. Although such a simple screen wouldnot be considered a purely “ethical screen” today, itstill serves as a milestone in the alignment of beliefand investment.Modern-day ethical investing is most oftenattributed to the great activist movements in the1960’s. At this time, the profound political changesthat were influencing the nation were also shapingthe way in which people began to invest their money.With a growing disdain for corporate America andanimosity towards the United States’ involvement By Melissa ArmsThe Park Place Economist / vol.The Park Place Economist / vol.The Park Place Economist / vol.The Park Place Economist / vol.The Park Place Economist / vol. VIIVIIVIIVIIVII22in the Vietnam War, college students, clergy, civilrights activists and eventually traditional consumerscoalesced to ensure their investments did not supportthe war. As time progressed, socially responsibleinvestors began to screen the companies in whichthey invested for broader initiatives such asenvironmental practices, whether the companysupported apartheid in South Africa and the way inwhich the firm handled its employees.(www.goodmoney.com)II. THEORY ANDLITERATUREREVIEWThe underlyingtheory concerning thetwo above hypothesescan be viewed asspanning two generalschools of thought. Forsimplicity’s sake, theywill be referred to fromhere on as pro-markettheories and pro-SRItheories.A. Pro-market theoryThe essence ofthis theory espouses that the returns received fromsocially responsible investments will be less thanthose produced by the general market (i.e. themarket will outperform SRI’s). To understand thebasis of this theory it is important to understand themechanics of traditional investing/portfolio creationand the capital asset pricing model (CAPM). TheCAPM maintains that if capital markets are efficient,traditional investing should produce a moreattractive risk/return ratio than SRI. The goal ofbasic portfolio creation is to amass the highestpossible return for some given level of risk.Non-systematic risk can be diversified away in orderto increase the efficiency of the portfolio. Therefore,understanding the concepts of risk, return,diversification and efficiency are essential to thisargument.The elements of risk and return form thebasis of the CAPM. It states that r-rf = beta(rm-rf)where r = a stock’s expected return, rf = the risk freeinterest rate, beta = the covariance of the stock inthe market portfolio and rm = the market’s expectedreturn. r-rf then becomes the expected risk premiumfrom a stock and rm-rf is the expected market riskpremium. (Peterson) An investment’s return issimply its expected profitability that changesaccording to varying performance scenarios; risk isessentially measured by beta and measures thecertainty or uncertaintywith which one can expectto receive a given return.An investment’s value,therefore, hinges on itsexpected return and thelikelihood that such areturn will be realized. Thelong-term relationshipbetween risk and returntends to be positive andlinear; the greater the risk,the greater the return andvice versa. In sum, anefficient portfolio will havethe highest expected returnfor a given level of risk orthe lowest risk for a givenreturn level.