Socially Responsible Investing by Universities and Colleges

• Author: Janet Kiholm Smith,Richard L. Smith
• Date: 01 December 2016
• DOI: http://doi.org/10.1111/fima.12125
• Published date: 01 December 2016

Socially Responsible Investing by

Universities and Colleges

Janet Kiholm Smith and Richard L. Smith∗

Weanalyze the socially responsible investing(SRI) practices of universities and colleges. Although

SRI may align with an institution’s mission and enhance its “brand,” these activities may also

arise from agency problems. Wef ind evidence of both effects.Consistent with branding effects, we

find significant differences between independent and church-affiliatedschools, we find that highly

selective and elite schools do not seek differentiation through SRI and are unlikely to sacrifice

returns for SRI, and we find that Less Selective schools appear to regard costs of SRI as branding

investments. Consistent with agency problems,attributes of investment committees bear on policy

choices. Forindependent schools, larger committees and those where professional representation

is low are likely to screen, allow sustainability considerations to influence investment choices,

and vote proxies along SRI lines. “Social boards,” those with more alumni and less investments

expertise, appear more oriented toward generating donations and less focused on investment

policy.

Although much has been written about socially responsible investing (SRI), surprisingly little

research has been devoted to the SRI practices of universityand college endowments. Universities

and colleges (referred to collectively as “universities” or “schools”) are an important investment

clientele. In 2014, aggregate endowments totaled more than $400 billion. In our sample, endow-

ment spending averaged 11.5% of annual operating spending. Brown et al. (2014) report that the

growth rate of the average endowment has far outpaced the growth rate of expenditures.

SRI takes account of both financial and nonfinancial perfor mance criteria. SRI investors may

consider a company’s governance and labor practices, its environmental impact and commitment

to sustainability, its geopolitical focus, and its product market orientation, such as tobacco,

weapons, or contraceptive production. SRI can take either of two forms—an institution may

express disapproval either by “voting with its feet” or by direct efforts to influence behavior.

“Negative screening” is the more common form among universities. Although not seeking to

directly influence corporate affairs, based on our sample, approximately 11.9% of public and

31.5% of private universities actively exclude specific types of investments. About 9.2% of all

schools positively tilt their portfolios based on sustainability considerations and about 12.6%

seek to influence corporate management through proxy voting.

SRI is paradoxical for universities in that trustees or regents have fiduciary obligations to

manage the endowment prudently, in a manner consistent with the school’s mission, donor

The research is supported by the Lowe Institute for Public Policy. We have benefited from discussions with Jim Floyd,

Henrik Cronqvist, Yawen Jiao, Lisa Meulbroek, and Joshua Rosett. We have received helpful comments from Keith

Brown, David Chambers, John Griswold, Laura Starks, Neal Stoughton, Josef Zechner, and other participants of the

2014 Endowment Asset Management Conference;from Ivo Welch, GerardHoberg, Eric Helland, and other participants

of the 2014 Southern California Research Conference;and from Peter Chung, Dave Mayers, and Thomas Kim and other

participants at the 2014 University of California Finance ResearchSymposium.

∗Janet Kiholm Smith is the Von Tobel Professor of Economics in the Robert Day School of Economics and Finance at

Claremont McKenna College in Claremont, CA. Richard L. Smith is the Phillip L. Boyd Professor of Finance in the

Anderson Graduate School of Managementat the University of California Riverside in Riverside, CA.

Financial Management •Winter 2016 •pages 877 – 922

878 Financial Management rWinter 2016

intent, and principles of sound investing. The puzzle arises because mission statements and gift

agreements generally do not address SRI and because portfolio theory implies that decisions to

eliminate certain investments from the portfolio or overweight others are expected to come at

a cost, by altering the risk-return trade-off relative to efficient diversification. The opportunity

costs of underdiversification can be material. Whether the trade-off is worthwhile can depend

on the mission/objectives of the university and the impacts of SRI policy on student and faculty

recruitment and donors. Because investment decisions are made by a board investmentcommittee

(IC), SRI policy may also depend on the “tastes” of committee/board members.

Weconsider two possible explanations for schools adopting SRI policies. The first is the brand-

ing hypothesis. Under this hypothesis, SRI policy could be a means of promoting a competitive

advantage that the school has carved out and seeks to sustain. Although policies of screening out

certain stocks are unlikely to materially influence corporate behavior, some elite private schools

promote their images as being at the forefront of shaping public opinion on social issues. As

an early example, Simon, Powers, and Gunnemann (1972) report that in the 1970s, Yale hosted

a national conference and debate exploring the “moral obligation” of universities in the SRI

arena. Similarly, some church-affiliated schools seek to advance the moral and ethical principles

of the religion. As documented below, other schools pursue branding strategies that can attract

students (and possibly faculty and staff) who are interested in promoting social responsibility.

Universities that seek to attract politically active liberal or conservative students may adopt SRI

policies designed to appeal to those groups. Accordingly, we test how policy choices relate to

selectivity, church affiliation, and campus political environment.

A second explanation for SRI policy choices is the agency cost hypothesis. An IC member

who sets policy and makes investment decisions may have a personal interest in promoting

certain social causes. Theory implies that agency costs are likely to be greater the less effective

is monitoring (Jensen and Meckling, 1976). Brown et al. (2014) study university responses to

financial shocks and find evidence of agency problems. Universities respond to positive shocks by

“hoarding” endowment (maintaining their establishedpayouts) but to negative shocks by reducing

spending. Monitoring may be particularly ineffective for nonprofit schools where generally only

the state attorney general and donors have legal standing to enforce adherence to the institutional

mission and the terms of gift agreements.1We test this by examining how SRI policy choices

relate to aspects the IC governance structure that are expected to be associated with agency costs,

namely, committee size, and representation of trustees, investment professionals, and alumni on

the IC.

Both hypotheses are predicated on the proposition that, in an efficient market, restricting invest-

ment choices comes at the cost of lower risk-adjusted performance due to underdiversification.

However, some empirical literature suggests that investors who adopt SRI strategies may some-

times be able to match or evenimprove upon the risk-adjusted returns of conventionally diversified

portfolios. Derwall et al. (2005), Statman and Glushkov (2009), and Kempf and Osthaff (2007)

all find that certain SRI strategies yielded nonnegative or positive alphas over certain historical

periods. The potential for ex ante improvements in performance hinges on market inefficiency,

such as unpriced benefits of “socially responsible” behavior.

Using survey data, merged with information from other sources, we analyze universitychoices

to employ SRI screens and to adopt other activist SRI practices. Consistent with the branding

hypothesis, we find that SRI investing is overwhelmingly a private school phenomenon in that

1See the commentary to the Uniform Prudent Management of Institutional Funds Act (UPMIFA) (National Conference

of Commissioners on Uniform State Laws, 2006). As of 2012, the Act had been adopted in all 50 states and the District

of Columbia. The UPMIFAreplaced the 1972 Unifor mManagement of Institutional Funds Act.

Smith & Smith rSocially Responsible Investing 879

private schools are much more likely to adopt SRI practices. Accordingly, our hypothesis testing

is focused mainly on private schools, both independent and church affiliated.

Also consistent with branding, we find that SRI policies of independent private schools are

much different from those of church-affiliated schools. Adoption of SRI polices is related to the

campus environment, including its liberal or conservative orientation. Contrary to the notion of

SRI thought leadership, elite and highly selective schools, are not unusual in their propensities

to adopt SRI policies. They are, however, significantly less willing than less selective schools to

sacrifice financial perfor mance for SRI objectives. We also find evidence supporting the agency

cost hypothesis in that SRI activism is significantly influenced by IC size and composition.

SRI activism is greater the larger the ICs of independent private schools. At church-affiliated

schools, committees with high percentages of trustee members are more likely to engage in SRI

activism. Representation on the IC by investment professionals acts as a countervailing force

against activism. Boards or ICs we identify as more social are less likely to engage in SRI.

This study makes several contributions. The findings provide insights into the nature of agency

relationships and agency costs in institutions other than publicly traded corporations. We also

providethe f irst empirical evidence on SRI investingas “mission investing” for branding purposes.

Finally, we provide original evidenceon attitudes toward accepting lower risk-adjusted investment

performance in pursuit of SRI objectives.

The remainder of the article is organized as follows. In Section I, we provide background on

important features of university endowments, including the influence of school mission on SRI

activism, the governance mechanisms adopted to overseeand implement investment policies, and

the fiduciary responsibilities of boards and ICs as they relate to the mission and SRI activism.

Related to fiduciary duty, we briefly review the theory on investment performance and under-

diversification, and the evidence on SRI performance. In Section II, we develop the hypotheses

and their empirical implications. In Section III, we describe the data and the variables used in the

analysis and present descriptive statistics. Section IV contains the empirical analysis and tests of

the hypotheses. Section V concludes.

I. Institutional Background

In the United States, public and private universities are charitable organizations structured as

nonprofit corporations, charitable trusts, or governmental subdivisions or agencies.2Generally,

these institutions have formally stated missions or charters that define their educational objectives

in broad terms.

A. Board ICs and Fiduciary Responsibility

For nonprofit institutions, responsibility for advancing the mission and maintaining adherence

to their principles is vested in the board of trustees. Hansmann (1990) and Winston (1999),

among others, note that the theory of the nonprofit sector is not well developed. In contrast to

for-profit corporations, universities do not have well-defined objective functions. Accordingly,

the board is entrusted to seek a balance among objectives that may conflict.3Normally, trustees

operate through a structure of board committees that focus on specific areas of responsibility.

2For-profit universities are not included in our study.

3Cejnek et al. (2014) point out that despite the voluminous body of research on corporate governance, we know little

about the relationship between university governanceand investment policies.