Assessment of Chinese green funds: Performance and industry allocation

Highlights

• We investigate the financial performance of all China green funds and the industry allocation differences.

• The performance of all China green funds is more exposed to small cap and value stocks.

• China green funds focus on manufacturing industries.

• The percentage of new intelligent manufacturing has an increasing trend in the new normal.

• Green funds industry allocation does take fully account of innovation in the new normal.

Abstract:

Facing the challenge of resource and environmental constraints, China has been adopted green development as the national strategy for pursuing sustainable long-term target at the stage of rapid industrialization, which naturally promotes green finance. The considerable growth in green investment within China has motivated intense debate on the implications of incorporating financial performance and green criteria into the portfolio selection process. However, few literature studies newly-emerged green funds' performance. This article tackles the financial performance of China green funds as well as analyzing the allocation difference across industries of green funds. We find that the performance of China green funds is sensitive to the market factor, small cap and value stocks for the full period. In contrast, after entering the new normal period, China green funds have not been sensitive to the market index, only to value stocks. Green funds play an important role in supporting the main direction of Chinese industrial restructuring and upgrading for the purpose of gaining new competitiveness in the markets. The study finds also that green funds exhibit different industry betas consistent with different portfolio positions. At the individual fund level, green funds have a high weight on manufacturing industries, which shows that China green funds have a characteristic of industry concentration instead of diversification; and steadily confirms that green funds' industry preference has a positive correlation with innovation indicators, indicating that innovation and R&D activities of enterprises are driving the new economy. Especially, the percentage of new intelligent manufacturing has an increasing trend in the new normal. Our findings suggest that green funds can work as a financial power to promote green technological innovation for industries, and to benefit small and medium-sized enterprises with new smart and green technologies.

Introduction

Green economy needs green finance. In light of the overwhelming scientific consensus on climate change and its worsening impacts, China recognizes the urgent needs for the action to meet the challenge. With growing public awareness of environmental issues, government policies and regulations play an important role in stimulating the development of green industries. Consequently, green investment funds emerge to the security markets. China has indicated support for a series of incentives to encourage green investment and financing, including refinancing projects, providing green credit support and a professional guarantee mechanism for fiscal interest discount, and establishing a national green development fund as well as promoting the green financial guidelines¹ to support the green financial development in recent years. Green funds invest only in companies that are considered socially conscious in their business dealings or directly promote environmental responsibility. Green funds provide investors with a channel to support businesses for green technology, such as alternative energy, green transport, waste management and waste recycling process as well (Jafari et al., 2017), which support sustainable living and other environmental friendly issues. Green investing strategies consider both financial returns and socially conscious goals in the processes of selection and choice of investment.

As the key for green finance, enterprises' green investment emerges from the socially responsible investing theme, which has been a hot investment niche in recent years. Wang et al. (2014) point out emphatically that it is essential for enterprises to have green investment for reducing greenhouse gases to increase their competitiveness in domestic and international markets. Accordingly, green funds are established with the explicit intention to meet the demand for incorporating green criteria into the investing process. In this context, green funds constitute an attractive response to investors' social concerns, meeting the increasing demand in the sense of sustainable global development. According to different criteria used in the selection of socially responsible investing, socially responsible investing funds (hereinafter, SRI mutual funds) include more specific fund groups, which include green funds (Climent and Soriano, 2011). Munñoz et al. (2014) also consider that green investing could be a subset of socially responsible investment.

Green and smart technology progress determines the green economic development. On the one hand, economic evidence makes it increasingly clear that smart action on climate change can drive innovation and strengthen economic growth. Technical progress is the most important factor to China's productivity growth (Wang and Feng, 2015). R&D expenditure does impact on green’ total factor productivity growth as well. This confirms that technological ability has a positively influence on productivity growth (Chen and Golley, 2014). On the other hand, Bosetti et al. (2011) find that the emergency of the advanced technologies plays an essential role in reducing the costs of climate stabilization. Green investment funds should first focus on financing the green technology.

Taking the above into account, the motivation of this paper is to evaluate the performance of Chinese green funds as well as the industry allocation of Chinese green funds. The considerable growth in green investment within China has motivated intense debate on the implications of incorporating financial performance and green criteria into the portfolio selection process. Our research will provide new points of view and new evidence to enrich the existing literature.

The underlying philosophy behind green funds can be understood from two angles. On the one hand, Friedman (1962) advocates that increased environmental performance will have a negative effect on corporate profitability. This means that additional costs associated with the screening and monitoring process of green funds will contribute to their lower financial performance. The additional costs of monitoring social performance will cause lower returns. On the other hand, green filters enable the identification and selection of firms with a higher quality of responsible management. These types of green funds usually have good records and access to better markets. Hence, green funds generate a good reputation and a superior financial performance. In this circumstance, analyzing the performance of Chinese green funds is necessary. The existing literatures related to SRI mutual funds, which can be classified into two strands. The first one is from a financial perspective to analyze the performance of SRI mutual funds. The second one is from the manager's management ability and behavior point of view to analyze the SRI mutual fund's financial efficiency. This study follows the first strand of the literature. Most of the existing studies focus on comparing the performance of SRI mutual funds with that of conventional mutual funds. They usually take a company perspective and survey the financial performance difference between SRI mutual funds and conventional mutual funds. Those literature focuses on the issue of whether it is possible that the SRI mutual funds can “do well while doing good” (Jo and Statman, 1993), which has attracted the attention of academics and practitioners worldwide, in attempt to provide evidence of SRI mutual funds being different from conventional funds. Why would we expect green fund performance to be different from that of conventional funds? First, green funds' managers pursue both profitable efficiency and sustainable goals. Second, the composition of green fund industry is also a unique factor. Green funds concentrate on investing in clean industry and efficient technology. Some environmental industry funds may be overweighed. Third, green funds focus on investment and take on risk through a reduced diversification. The mainstream of the research is closely related to how SRI funds are empirically evaluated. In general, the majority of empirical results find no significant difference in the performance of SRI and conventional mutual funds. Using an international sample of 103 ethical mutual funds, Bauer et al. (2005) overcome the benchmark problem and find that ethical mutual funds experience a catching-up phase. Similar to prior research, there is no significant difference between ethical and conventional funds. Cortez et al. (2012) provide empirical evidence on the performance, as well as the style, of SRI mutual funds between the European market and the US market. The results show there is no significant difference between these two markets. The investment style of SRI mutual funds is strongly exposed to small cap and growth stocks. By applying a conditional multi-factor, Bauer et al. (2006) investigate three equal sub-periods of Australian ethical funds versus conventional funds, and find that the difference between the performances of ethical funds and conventional funds is statistically insignificant. Australian domestic ethical funds experienced a catching-up phase. There was no financial penalty for Australian ethical fund investors from 1992 to 2003. Cortez et al. (2009) assess the performance of SRI mutual funds from European countries investing globally in comparison to conventional and socially responsible benchmark portfolios. Their results provide evidence that the performances of European SRI mutual funds are comparable to those of conventional or socially responsible benchmarks. SRI mutual funds are more sensitive to conventional indices than to socially responsible indices. However, investors could also benefit from buying an exchange traded socially responsible indices fund without sacrificing their conventional gain.

However, some studies do find that SRI mutual funds perform better than conventional funds. This difference may result from sample size, time period and benchmarks. Kreander et al. (2002) analyze the financial performance of 40 European ethical funds from 1996 to 1998. After being adjusted for risk, they conclude that a few ethical funds significantly outperform the benchmark and none of those funds have positive market timing ability. The results suggest that fund size and Jensen alphas may have a significant positive relationship. Kempf and Osthoff (2007) study the implementation of a strategy based on buying high socially responsible stocks and selling low socially responsible stocks. This strategy can obtain an abnormal return of up to 8.7% per year. This research also begs a question, “Does it result from a temporary mispricing in the market, or does it compensate for an additional risk factor?” Renneboog et al. (2008) provide an overview of the literature on SRI and raise the open questions in term of corporate finance, how does corporate social responsibility (hereinafter, CSR) influence the cost of capital and the investment decisions? It also addresses the issue to examine the incentive structures in the SRI industry.

Although SRI mutual funds' financial performance has been widely studied, there are few academic papers that have addressed newly-emerged green funds' performance. White (1995) is the first to analyze and compare the financial performance of green funds between the German and US markets. The results show that German green funds fare better than US green funds. In general, German green funds do not perform differently from the German stock market. Climent and Soriano (2011), by using a matched-pair, analyze the performance of US green funds and conventional mutual funds from 1987 to 2009, but demonstrate that US green funds underperform their matched peers. However, if switching to the more recent period of from 2001 to 2009, there is no significant difference between green funds and conventional mutual funds. Compared to traditional mutual funds in the US, Chang et al. (2012) find green mutual funds have generated lower returns. In contrast, considering both time-varying performance and risk measures, Silva and Cortez (2016) document that the performance of US and European green funds performed better during the crisis period.

The contribution of this paper to the literature is twofold. First, to the best of our knowledge, this is the first study to have evaluated the performance of an emerging economy's, such as China's, green funds during a transfer time period (2010–2016). To pursue the social objective, green funds generally support energy-saving, environmentally friendly, high tech with a decent return projects. This setup allows us to examine the function of China green funds in the process of structure transformation. We find that China green funds are more exposed to small cap and value stocks because of the guidelines for establishing a green financial system policy for the purpose of reducing financing costs of small firms. Under the guidance of a government, the establishment of Public-Private-Partnership cooperation improves the degree of small companies' participation in the environmental protection industry. The Public-Private-Partnership pattern merges the environmental protection industry with the financial target, effectively guiding private investment in green development. It is a major path for promoting the progress of green funds. At the same time, green funds are in accordance with the market mechanism, which are advantageous to the sustainable development of the green industry. This paper also investigates if China green funds change their investing styles and how their performance determinants are changed in the new normal period. Therefore, we consider the new normal bias (2013) and re-examine the performance of China green funds before and after the beginning of the new normal. El-Erian (2010) points out that lower output growth post 2008 financial crisis for advanced economies is the new normal. Candelon et al. (2016) further interpret that the decline in output growth following a crisis is a new normal accompanied by strong structural reforms. China also meets its new normal of the economy with more prefunded reforms in supply side, in which firms need more technological innovation. It will not come as a surprise that we also find that China green funds are less sensitive to value stocks during the new normal period. Because value stocks usually invest in traditional industries. This shows that China's economic structure is in the process of being upgraded. Second, we find a high degree concentration in industry composition of China green funds. We test whether there exist differences in the industry allocation of China green funds, and their unique performance as well. We contribute to this line of research and examine the performance of green portfolios by tracking the actual asset allocation decisions of individual green funds. The industrial sector has a significantly higher relation to green fund performance compared to other industries. We find that China green funds have a characteristic of industry concentration rather than one of diversification. Green funds employ a set of investment screens that restrict their investment opportunities. Compared with the US and the EU, the scale of the Chinese manufacturing industry ranks first worldwide. In 2013, China's manufacturing output accounted for 20.8%, making it the largest in the world. With the rapid development of China's manufacturing industries and unceasing strengthening of environmental resource constraints, we are still faced with the task of reducing carbon emissions. The Public-Private-Partnership patterns of green funds have the potential to be conducive to the environmental governance of the market.

The remainder of this paper is organized as follows: Section 2 presents the data we use. Section 3 describes the methodology used to assess green fund performance and industry composition. Section 4 provides the empirical results. Section 5 presents the robust test and Section 6 discusses the main results of our study and concludes.