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«Global TrusT and EThics in FinancE Innovative Ideas from the Robin Cosgrove Prize Carol Cosgrove-Sacks / Paul H. Dembinski Editors Trust and Ethics in ...»

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Voluntary compliance would allow market forces to govern the pace of adoption of the Standards. Positive externalities could lead to broad compliance with the Standards despite their voluntary nature. When a voluntary compliance scheme is successful, the value of compliance increases as more entities claim compliance. Based on the increase of SRI funds as a proportion of total investment funds, and particularly the rapid growth of SRI mutual funds, compliance with the Standards could afford a competitive edge to compliant companies with respect to their financing options and to investment managers with respect to their assets under management. In the extreme case, compliance with the StanTrust and Ethics in Finance dards might ultimately be regarded as a necessary cost of obtaining corporate financing or assets under management, much as many companies and fund managers are willing to incur the high cost of securities regulatory compliance in order to be eligible for public investment. Thus, if the Standards are appropriately defined, natural market forces could eventually lead to widespread adoption without legally mandating compliance.

Natural market forces will set the pace of adoption

The law is not a viable means of implementing well-formulated global social impact rating standards. Foremost, the large number of legal jurisdictions and securities regulators and the persistent lack of harmonisation make it logistically unfeasible to require globally uniform social impact ratings and disclosures for all regulated companies and fund managers. If mandatory Standards were implemented with due attention to the variations among existing regulatory regimes, they would be too broad to offer useful information for investors. On the other hand, if mandatory Standards were specific enough to be valuable for investors, broad legally-mandated compliance would disturb the capital markets by imposing uniform standards through otherwise unharmonised regulatory regimes. Neither of these options could satisfy both investors and regulators. Despite the present trend in some jurisdictions in Europe and, to a lesser degree, in the US, that requires disclosure of some social impact factors, uniform rules-based global social impact rating standards are not a good candidate for implementation through legislation.

Furthermore, avoiding a legally mandated compliance model could help to ensure that developing countries are not left behind. If compliance with the Standards was mandated by law, it is conceivable that the less developed capital markets and less robust regulatory regimes that exist in some developing countries could cause these markets to be left out of the initiative altogether. An implementation mechanism that relies Social Impact Ratings 183 on voluntary compliance is more capable of permitting companies and fund managers in each market and jurisdiction to comply with the Standards at a pace that is dictated by natural market forces. With globalisation of the capital markets and the investment sector, respectively, companies and fund managers increasingly compete for financing and assets under management throughout developed and developing markets. For this reason, implementation through voluntary compliance rather than legislation is the best means of ensuring truly global standards that are eventually adopted by a critical mass of companies and fund managers in all markets.

Notwithstanding the problems inherent to legally mandated compliance, companies and fund managers could still be encouraged to claim compliance with the Standards and provide the relevant disclosures in their regulatory filings as a best practice (e.g. in annual reports, as suggested in the third UN Principle, above). This would invite regulatory sanctions for false claims of compliance, due to the severe repercussions of including misleading information in a regulatory filing. This means of guarding against false claims of compliance is similar to that employed by the GIPS. While refusing to comply with the GIPS does not violate any law, a false claim of compliance can lead to sanctions. For example, according to the CFA Institute’s Centre for Market Integrity, the United States Securities and Exchange Commission has sanctioned investment managers for falsely claiming compliance with the GIPS. Similar to the GIPS, the most viable means of implementing the Standards is a voluntary compliance scheme that relies on regulatory force only to avoid false claims of compliance without actually making compliance mandatory.

Arguments for standardised ratings At present, a social impact rating provider must define its own rating criteria and calculation methodology, gather relevant information for 184 Trust and Ethics in Finance each company to be rated and calculate and update the social impact rating according to the calculation methodology. This process is complicated and expensive due to the diversity of existing rating systems and limited publicly available information about relevant corporate practices. Widespread adoption of the Standards could be expected to reduce these costs due to standardisation and economies of scale.

Standardised ratings would eliminate the need for each rating provider to develop its own rating scheme and for each company to be rated by several providers. The burden of turning up data relevant to a company’s social impact rating would fall to the company seeking to claim compliance rather than external rating providers. The company is in the best position to gather the relevant data, while an independent rating provider is in the best position to provide unbiased evaluations of that data. In this manner the role of the rating provider could evolve from a research function to a corporate service function whereby the rating provider produces ratings in accordance with the pre-defined Standards using data that is furnished by the company. Independent audits are already the norm for environmental sustainability reports and it is quite conceivable that the audit methodology could be standardised and extended to include other social impact factors.

Furthermore, as noted above, there are positive externalities associated with a voluntary compliance scheme because the value of compliance increases as more companies and fund managers comply. The pace of adoption by companies and fund managers can be expected to accelerate with time. Due to standardisation, a social impact rating prepared in accordance with the Standards would be an undifferentiated product.

As the market for this product grows, an economy of scale would result.

In contrast with the present growth of SRI, which has led to more research providers offering competing rating schemes, the service of producing social impact ratings could be commoditised through standardisation. The cost of obtaining social impact ratings could reasonably be Social Impact Ratings 185 expected to fall as rating providers compete to offer a standard service in contrast with the present competition to offer a custom product.

Similar to the GIPS, a key benefit of the proposed Standards would be the uniformity of social impact disclosures, which would facilitate reliable comparisons. If widespread voluntary compliance with the Standards can be achieved, the proposed portfolio social impact ratings and the method for identifying socially dominant portfolios described above would be much more practical for most investors. Further to these simple proposals for socially conscious portfolio management, more complex quantitative social impact metrics could also be developed once standardised ratings are widely available. Given accepted techniques for the incorporation of social impact ratings into quantitative investment analysis, investors would have the necessary information to make informed socially conscious investment decisions among all available investment portfolios. By facilitating comparisons among a wide variety of mainstream and SRI investment portfolios on the basis of social impact, the Standards would expand the scope of investment opportunities that are available for consideration by SRI investors.

A great potential

For investors seeking to consider social impact in addition to return and risk, social impact ratings can enable all of these factors to be incorporated into quantitative investment analysis. Portfolio social impact ratings and the concept of socially dominant portfolios supplement modern portfolio theory with an analytical technique for socially conscious investors. Just as the reliance on standard deviation as a quantifiable risk measure has facilitated quantitative risk analysis, social impact ratings have the same potential to apply a quantitative analytical approach to SRI. Some SRI investors, particularly those who base social screens on religious beliefs, may be committed to absolute ethical exclusions.

However, positive screening and quantitative analysis based on relative 186 Trust and Ethics in Finance social impact ratings still hold great potential for a large segment of the SRI investing world.

For this potential to be fully realised there must be a uniform social impact rating system. The UN Principles have laid the groundwork for incorporating social impact into investment decisions but specific rulesbased standards are necessary to fully realise the analytical value of social impact ratings. Global social impact rating standards could be developed from the UN Principles if the signatories to the Principles are committed to incorporating social impact factors in quantitative investment analysis. The CFA Institute’s GIPS are a good model for voluntary compliance with clear, pre-defined rules that facilitate reliable comparisons. If properly formulated, the Standards could play an important role in bridging the gap between traditional SRI and the quantitative techniques that lie at the root of modern portfolio management.

Appendix: Quantitative application of social impact ratings for a two stock portfolio The following is an illustration of the quantitative concepts discussed in this paper, based on a simple two stock portfolio of financial services companies using actual economic data. All figures are rounded to two decimal places.

The first table sets forth the assumptions used in this model. Fannie Mae (FNM) and Morgan Stanley (MS), respectively, received the highest (14.6) and lowest (8.2) TSITM Ratings for financial services companies in the S&P 500, as rated by the Total Social Impact Foundation, an American not-for-profit organisation (these ratings are from 31 December 2003, which is the last time for which TSITM data is available). The expected annual return for each stock is based on analysts’ average 2007 target prices and the risk free rate is assumed to be the yield on a 10-year United States Treasury bond at the time of writing (4.69%). The stocks’ expected excess returns are their respective expected returns minus the risk free rate. The stocks’ standard deviation and correlation are Social Impact Ratings 187 calculated based on their respective excess stock returns over the last ten years.

The Sharpe ratio is calculated from this data.

^^d , Z dZ/^d/^ E Z/^ &Z Z d

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This second table includes the relevant calculations for each of 11 different combinations of the two stocks, ranging from the portfolio that is 100% invested in MS (portfolio 1) to the one that is 100% invested in FNM (portfolio 11). It illustrates how the proposed quantitative concepts can be applied in practice.

Portfolio social impact ratings For each portfolio, the final column calculates the portfolio social impact rating based on the weighted average social impact ratings of FNM and MS.

Socially dominant portfolios Pursuant to modern portfolio theory, portfolios 2, 3, 4 and 5 are risk-efficient portfolios insofar as they offer higher risk-adjusted returns than all other portfoSocial Impact Ratings 189 lios (i.e. they have the highest Sharpe ratio, 0.25 after rounding). However, assuming each portfolio satisfies any applicable required return and/or maximum risk parameters, these portfolios are equally preferred because they offer a similar Sharpe ratio. Portfolio 5 has a higher portfolio social impact rating (10.76) than each of portfolios 2 (8.84), 3 (9.48) and 4 (10.12). On this basis, portfolio 5 is the socially dominant portfolio and is preferred by the socially conscious investor.

The author gratefully acknowledges contributions from the Total Social Impact Foundation Inc. and KLD Research & Analytics, Inc., which were kind enough to provide samples of their proprietary research for the purposes of this paper.

References CFA Centre for Financial Market Integrity, 2005. GIPS Fact Sheet, www.cfainstitute.org/aboutus/press/pdf/GIPSfactsheet2005.pdf.

Kinder, P.D., 2005. Socially Responsible Investing: An Evolving Concept in a Changing World, Boston, KLD Research & Analytics, www.kld.com/resources/papers/SRIEvolving070109.pdf.

Kinder, P.D. and Domini, A., 1998. Social Screening: Paradigms Old and New, Investment Research Guide to Socially Responsible Investing, Plano (Texas), Investment Research Forums.

UNEP Finance Initiative and UN Global Compact, 2006. The Principles for Responsible Investment, www.unpri.org/files/pri.pdf.





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Finance and… ethics. As you see these two words next to each other, you may feel some tension, or even a slight discomfort. Or you may even smile coyly, thinking they do not belong together. You may spontaneously remember the global financial crisis and shake your head in disbelief thinking of the damages that are still felt across nations and organisations. Or you may belong to a large portion of the population that does not trust institutions, corporations, politics, business people and finance professionals. Even before the crisis reached its pinnacle, a US Roper poll conducted in 2005 showed that close to three quarters of respondents believed wrongdoing was widespread in industry. Only 2% felt that leaders of large firms were “very trustworthy.” Recent events have certainly not improved their image.

In this paper, I attempt to convey that what I’ve just described are only symptoms of a much deeper issue. We built a global framework of scientific, industrial, financial, economic, and informational systems.

Yet we lost meaning, value, and ethics in the process.

192 Trust and Ethics in Finance By holding both finance and ethics in my consciousness, I feel an invitation to recover what has been broken, to integrate what has been fragmented. I extend this invitation to finance professionals – who are usually very at ease with the tangibles – to explore the intangibles and to integrate the world of the visible and the world of the invisible.

Derivatives gone mad

Indeed, we did master the technical or exterior dimension of doing business and finance. I’ll just use the example of derivatives to illustrate this point.

The derivatives market has grown from $100 trillion to $500 trillion in 2007. “The total world derivatives market has been estimated at about $791 trillion face or nominal value, that’s 11 time the size of the entire world economy” (en.wikipedia.org/wiki/Stock_market). In July 2008, the Jutia Group reported that global derivatives had reached more than one quadrillion dollars (that’s one followed by 15 zeroes!): $548 Trillion in listed credit derivatives and $596 trillion in notional/OTC derivatives.

And if these raw numbers still do not talk to you, just take a look at the

following graph:

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