Are ethical mutual funds safer than conventional mutual funds in the European market? : A matched pair analysis of the risk in ethical mutual funds based on three GARCH models´estimates from a five factor model

Abstract: Background: Ethical investing is growing in importance due to investors’ concern with environmental and social issues. However, there is difference of opinion regarding the extent to which the limited investment universe affects the financial return of ethical investments. Recent empirical findings suggest that while there is no statistically significant difference in the returns of ethical and conventional funds, ethical funds tend to be less risky due to having better managed firms in the portfolio. More nuanced conclusions are drawn by Nofsinger and Varma (2014) who provide evidence that US ethical mutual funds outperform conventional funds in times of crisis at the cost of underperformance in non-crisis times, indicating that ethical funds are “safer” investments. Purpose: This thesis builds on the latter findings, focusing on the European market instead. Its purpose is to examine whether European ethical mutual funds are safer than European conventional mutual funds in times of crisis and non-crisis. An analysis of the ethical funds’ screening-styles, returns and risk factor loadings will be performed to explain their volatility relative to conventional funds. The empirical investigation is based on a matched pair analysis of 33 European ethical mutual funds and 33 European conventional mutual funds with a European investment universe between 01-2005 and 01-2015. Method: Volatility in the funds’ returns is estimated econometrically by means of three types of GARCH models (GARCH, TGARCH and EGARCH). To explain volatility differences, we moreover calculate the funds’ risk factor loadings from a five factor model. In addition, we test to what degree the variance in the ethical funds’ returns is influenced by screening techniques, and whether there are any significant differences regarding the techniques being applied. Conclusion: Basedonthevariance,weobservethatethicalfundshavealowermeanreversionfroma shock and greater exposure in the volatility to certain market news. We moreover show that they are less exposed to systematic market risk and small firms. During the crisis we find that ethical funds react more to certain market news but less exposed to the systematic market risk. The empirical results also suggest an overperformance of ethical funds in times of crisis at the expense of underperformance in times of non-crisis, indicating support for Nofsinger and Varma’s (2014) conclusion. The PRO/ESG screen exhibits an asymmetric return while the Best-in-Class approach has the highest return and lowest variance.