How well can an investor do by doing good? The question pits traditionalists against a newer breed of “socially responsible” investors who don’t want their money to support companies that do things they disapprove of, such as selling tobacco products, alcoholic beverages or weapons. Investors concerned about social, environmental, labor or religious issues may be willing to sacrifice some financial return. But how much must they give up?

“Sometimes being socially responsible is costly, and sometimes it isn’t,” says Wharton finance professor Robert F. Stambaugh. “It depends on what kind of investor you are.”

Stambaugh and his Wharton colleagues finance professor Christopher C. Geczy and graduate student David Levin report the results of their recent study in the paper, Investing in Socially Responsible Mutual Funds . They have found that when returns are adjusted for risk, index-style investors give up very little by using socially responsible funds, while investors who choose actively managed funds can pay a heavy price – losing more than 3.5 percentage points of return a year. Theirs is one of the first studies to look at socially responsible investing on a risk-adjusted basis. “Over 30 years, 3.5% a year is a huge amount,” Geczy says.

There are far fewer socially responsible funds than ordinary funds. As an investor’s criteria for choosing funds get narrower, there is a growing chance that the best performance will be delivered by non-socially responsible funds. So the investor who puts great stock into the track records of active managers, and wants to focus on a narrow segment such as small-stock value funds, may sacrifice a lot of performance by limiting himself to socially responsible funds, Geczy notes. “It would be hard to believe that you would not pay a cost” for severely reducing the acceptable fund choices, he adds.

Traditionally, investors assessed their results with simple criteria – financial return. The goal of business was to make money, pure and simple. But not all investors see it that way, and the past decade has seen an enormous growth in socially responsible investing strategies, or SRI, that reject stocks and bonds issued by companies that do not satisfy some non-financial criteria. While the tobacco, alcohol and weapons bans are the most widespread, many strategies look at environmental and labor-relations issues, and some follow religious guidelines.

At the end of 2001, about 12% of all assets under management, worth about $2.34 trillion, were subject to some type of social screen, according to studies cited in the paper. These included pension funds, such as the California Public Employees’ Retirement System, and other institutional investments.

Although there were 219 socially responsible mutual funds with assets of about $154 billion at the end of 2001, the study focused on 35 no-load equity funds that could provide at least three years of data on returns, expenses and turnover. The sample and its subsets were large enough to represent the entire SRI universe, the authors say.

The study compared the risk-adjusted performance of SRI funds and comparable non-SRI funds, drawn from a universe of 894 no-load funds. It found that as investment strategies got narrower, SRI investors paid a larger price in lost return. Since there are fewer SRI funds, it is difficult to get enough diversification to minimize risk. The problem becomes greater as investment strategies become more restrictive – limiting investments to value or small-company stocks picked by active managers, for instance.

“The funds from the broader fund universe that happen to have the most spectacular track records are not present in the smaller universe of SRI funds,” the authors write.

Aside from the social screens, SRI funds tend to have slightly larger expense ratios, due to the extra effort required to examine investments for SRI issues. But the difference was very small, with SRI expense ratios averaging 1.33% a year, versus 1.10% for non-SRI funds. At the same time, SRI funds enjoyed some cost efficiencies, since their annual portfolio turnover was less than half that of the non-SRI funds – 81.5% versus 175.4%.

At one extreme, the study looked at how the index-fund investor would fare. Index investors attempt to match the performance of the entire stock market, or a large portion of it represented in an index such as the Standard & Poor’s 500. They don’t believe that active managers can beat the market average over time, and they benefit from low management costs and the low trading costs associated with low turnover.

The study found that the investor who chose three large SRI index funds would enjoy returns averaging only 5 basis points per month, or 0.6% a year, less than they could make in comparable non-SRI index funds. SRI index funds can find enough stocks satisfying their social screens to closely resemble the non-SRI indexers. The Domini Social Equity fund, for instance, uses an index of 400 socially acceptable stocks, while the non-SRI S&P 500 index funds have 500 stocks.

An investor who believes active managers can boost annual performance by a modest one percentage point a year would emphasize different funds based on managers’ track records, but still would give up only 7 basis points per month in performance by choosing SRI funds, the study shows. However, an investor who thought active managers could boost performance by a substantial 3.5 percentage points a year would have a dramatically different portfolio and would make a major sacrifice by focusing on SRI funds – 99 basis points a month, or nearly 1%.

Basically, the more the investor emphasizes manager’s track records, the more likely it is that the best performing funds will be non-SRI funds. The SRI commitment thus often means picking weaker funds.

Adding other investment criteria increases the sacrifice. The index investor who prefers small-company value stocks, for instance, gives up an average of 31 basis points of performance a month – about 3.7% a year by insisting on SRI funds. The investor who believes in active management for small-cap value stocks and insists on SRI funds may give up 150 basis points a month – an enormous 18% a year.

For the ordinary investor, the study’s implications are fairly simple. “If they are used to investing in index funds and they have a streak of social responsibility, there are good alternatives that would allow them to satisfy that socially responsible urge,” Stambaugh notes. For the index investor, the cost of using SRI funds may average only 0.5% a year, Geczy adds.

But investors who want to use managed funds to bet on narrowly defined sectors, such as value stocks, had better take care, according to Stambaugh. “They had better think about how much economic value they are willing to attach to their social responsibility,” he says. “They will give up some expected gains.”