When you look at socially responsible or green investment mutual fund performance do you ever wonder why the returns are so closely correlated?
This does not happen by chance as the correlations of fund groups tend to run very tight regardless if they’re SRI funds or not. Investors, both professionals and amateurs alike tend to invest with a herd-like instinct. But there is another factor might be the single largest reason and that is Market Capitalization or Liquidity.
Mutual funds are businesses first and foremost and become more profitable as they grow larger in size. The problem with being larger in size is that it forces the fund to only consider stocks large enough to absorb the funds purchases without significantly moving the stock price. By moving higher up in capitalization there are not only fewer stocks to choose from but the returns are correspondingly reduced*.
Hence the vast amount of mutual funds especially U.S. Large Cap funds are choosing to fill their portfolios from typically no more than 1000 stocks. If they choose to benchmark the fund to the S&P 500, there may be no more than 500 stocks for the fund manager to select from. These 1000 stocks are the most heavily researched and scrutinized as well so that its hard to possess information that is not already dispersed amongst investors, this is a very hard arena to compete with.
There are alternatives and solutions to herd-like returns on investment and that is to own a portfolio not trapped by the restrictions of considering such a small number of investments. For example, in our privately managed portfolios we consider over 10,000+ investments every day. This allows us to avoid herd behavior and research investments that could never be considered for a larger fund, a considerable advantage in our opinion.
In sum, there is very little deviation in the holdings of U.S. mutual funds especially Large Cap funds. This is primarily due to their business structure which demands that investments trade on scale that can absorb tens of millions of dollars daily. There is also the issue of career risk as no manager wants to stand out on the downside in annual reviews, hence it may be better to join the pack rather than deviate from them. Either way, socially responsible investors should not expect above average performance over a multi-year time horizon as informational advantages are minimal at best.
Brad Pappas
*(See “Contrarian Investment, Extrapolation and Risk by Lakonishok, Shleifer and Vishny. Journal of Finance, December 1991)