Lowering Portfolio Risk with Corporate Social Responsibility

Abstract

This article examines the link between corporate social responsibility (CSR), as measured by the Kinder, Lydenberg, and Domini Research and Analytics Inc. (KLD) data, and the likelihood that a firm experiences an extreme return in a given year. An extreme-return firm is defined as one that has a return either in the top or bottom 3% of all firms with CSR data. The authors find CSR is negatively related to the likelihood of a firm experiencing an extreme return. Accounting for this negative relationship significantly improves a model used to predict future extreme returns. Finally, they form two portfolios: one with all firms with CSR data and one with all firms with CSR data except those firms with the highest predicted probability of extreme returns in the following year. Our results indicate that the returns for the two portfolios are nearly identical. However, the standard deviation of the portfolio excluding likely extreme movers is 3% lower than the portfolio with all firms. Thus, this simple portfolio strategy incorporating CSR has the potential to lower risk without impacting return.

TOPICS: ESG investing, portfolio theory, portfolio construction