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An encouraging empirical finding is the growing market share and awareness of Socially Responsible Investment (SRI). This approach pays much attention to Principles for Responsible Investment (PRI), the UNEP Finance Initiative collaboration with the UN Global Compact (www.unpri.org). An ever-increasing list of major institutional market participants have signed up to the voluntary codes of conduct of this programme. It can be seen as a clear indication of an emerging shift in our social norms; a larger degree of corporate social responsibility is required. The are some signs that ethics are starting to be integrated into finance.
Investing as if People and Planet Mattered 357 An important observation in the SRI market is that small retail investors still hesitate to participate in responsible investment. North America has a slightly better record than continental Europe, where many countries seem completely disinterested in retail SRI (www.eurosif.org). This is quite strange, as the retail sector in particular is made up of the general public, and can therefore be the very source of emerging moral values. Additionally, this segment is the key stakeholder in the act of protecting the environment and acting as watchdog for social concerns. The immaturity of retail SRI seems puzzling yet it has previously been observed that small retail investors occasionally show perplexing behaviour. The usual suspect is their potential lack of understanding of investment characteristics, and of risk in particular. Now the somewhat inaccessible concept of a social impact factor has been added, and the intricate combination may lead us towards an explanation.
The forthcoming analysis emphasises two frontiers in implementing ethics in finance. The first rationalises retail investor’s awareness of the potential ethical implications of their investment decisions. This is an attempt to increase the level of deliberate choice in retail investment decisions, irrespective of their nature, and whether they are responsible or neutral. If a moral code of conduct of a society is rooted in the general public’s behaviour, the most direct way of affecting the system is by a bottom-up change in behavior. Strengthening conscious, deliberate consumer choices in the financial market by mainstreaming responsible investment by the retail sector may accelerate a positive progression. The second frontier recognises the culture among participants in the financial market as being a major facilitator of integrity and a fixation on the rational value-maximising paradigm. It argues how crucial a factor education is in developing a sound relationship between these conflicting concepts. Implementing ethics in finance thus requires an investment in the skills of future market participants.
358 Trust and Ethics in Finance
A new portfolio allocation
The SRI mutual fund industry is keen to announce the performance of their activities compared with conventional counterparts. Over the last ten years, researchers have been eager to investigate whether environmental, social and governmental (ESG) factors hold additional financial information, that has not yet been recognised by the general market (Renneboog et al., 2007). Findings are not strictly homogeneous but the general conclusion appears to be that the SRI mutual fund industry is not outperformed by their value-neutral competitors. It leads to the convenient but perhaps hasty conclusion that portfolio responsibility can be provided as a free add-on to an investment. Still, it is definitely a positive dimension to add to the promotion of SRI From a theoretical point of view it is also a very motivating result.
Classical portfolio mean-variance analysis suggests that any limitation to the investment universe will naturally cause diminishing opportunities for diversification and imply higher risk taking or lower expected returns on portfolios. Likewise, it means that social ratings should include extra financial information that has hitherto not been used in the market, and that the advantage is sufficient to cover the costs of diversification.
Alternatively, it may be interesting to take a closer look at exactly how different the holdings of SRI mutual funds really are compared with value-neutral funds (Hawken, 2004). The fact that a lax definition of sustainable, green and responsible investment is leading actors in the financial market to focus mainly on financial performance might be an emerging concern. Portfolio responsibility analysis might be limited to a bare minimum and only considered applicable to the extent that it does not interfere with the risk-return profile of the investment. Wisebrod (2007) suggests a technique for choosing a portfolio, where responsibility is preferred to the extent that it is possible to do so without worsening the financial risk-return profile.
Investing as if People and Planet Mattered 359 The turning point is reached, however, when the subset of funds aim to have a significantly positive impact on social or environmental concerns. They are also confronted by the market sentiment that responsibility should come as a free add-on. But does our environmental situation allow us to only consider climate change to the extent that it does not affect our financial performance? Any sincere stakeholder in the environment would probably say no. Exercising this view in the investment decision requires a new type of portfolio allocation that is equipped to allow for personal values.
Quantification of values
Within portfolio theory the utility function is a tool that is often applied in order to express a potential preference for certainty. It is generally accepted that small retail investors are somewhat or even very riskaverse, and the utility function can easily capture this feature in the allocation of assets. Questionnaires on gambling preferences are often applied in order to perform the actual quantification. A logical way of incorporating preferences for responsibility could therefore be to enhance this utility function with another dimension (Hallerbach et al., 2002).
Wisebrod (2007) suggests that the habitual mean-variance analysis can be applied to an investment universe such as that situated in the group of investments that have the highest Sharpe’s ratios, i.e. the optimal portfolios, the socially dominant portfolio is chosen. The Sharpe’s ratio is conventionally calculated as the expected portfolio excess return per unit of risk inherent in the portfolio. If the investor is not willing to compromise on the risk-return profile of the investment, then this approach is quite sufficient. If, on the other hand, the investor has a strong preference for responsibility and for certainty, then this method does not necessarily provide the best solution. The rational, responsible investor will consider the broader set of portfolio attributes: risk, expected return and responsibility.
360 Trust and Ethics in Finance It is therefore necessarily to quantify the preferences for certainty and responsibility in an integrated manner (see Figure 1). It means that two out of the three relationships need to be determined, since the third relationship will be implicitly given.
/ Creating the right incentive One way to establish the responsibility trade-off is to confront the
investor with two opportunities as follows:
• A portfolio with a high and transparent social or environmental impact and with a given Sharpe’s ratio.
• A neutral investment constructed using the market portfolio, i.e. the tangency portfolio of the capital market line in the mean varianceanalysis.
The latter is the optimal portfolio when considering only financial aspects. By construction it has a higher Sharpe’s ratio than the prior opInvesting as if People and Planet Mattered 361 portunity since the market portfolio is defined by the highest possible Sharpe’s ratio that can be obtained in a given investment universe.
The question is therefore: what social rating creates the right incentive for the responsible investor to choose one investment over another?
The investor can decide to be neutral, or only want to make a responsible investment if it does not largely affect the risk-return profile. Yet, the investor should also have the opportunity to prefer a certain responsibility profile on the grounds of either a lower expected payoff or a higher acceptable risk.
This is the essence of the determination of preferences for responsibility. Note that the general concept of socially aware consumption already takes the quantification of non-materialistic personal values into account. Consider the example of goods sold under the Fair Trade label or something as common as organic produce. Both embody the quantification of a price premium based on a personal belief or benefit to the consumer.
The example of organic produce is, however, only valid in this setting when considering the positive environmental impact of the sector, i.e. not considering the health implications of not consuming dangerous chemicals.
The problem of the responsible investor is how to choose a weighted investment portfolio, w. It summarises the common maximisation of expected utility, both financial and non-financial, at maturity of the investment (see Box 2).
The setup is technically simplified yet should be conceptually clear:
the investment universe is evaluated with integrated preferences for certainty and responsibility.
362 Trust and Ethics in Finance The right investment The investor is now equipped to choose an investment that fits with his or her personal values. Some indexes, as the Dow Jones Sustainability Index (DJSI), have established themselves on the best-of-industry method. DJSI World includes the 10% highest socially rated companies in a number of different sub-sectors guaranteeing a reasonable diversification profile (www.sustainability-index.com). This type of approach is meaningful, well explained and well founded.
Many SRI mutual funds also establish themselves with similar strategies. For the small retail investor choosing a responsible investment according to the previous section, however, it may not provide the best type of investment. Firstly, the improvement on the common industry average that the index or fund embody in their holdings may not be information that is readily available to the retail investor. Secondly, most of a given industry may not have a major impact on a given social or environmental factor, as even the top 10% can havevery variable attitudes to sustainability. Thus, if an investor is particularly interested in social welfare and global issues, it might be worth selecting a smaller basket of stocks with very high social ratings in the particular area of interest. This would imply that the investor could obtain a large utility premium on the social side in the equation defining the utility function U.
An investor who is willing to compromise the risk-return profile in order to obtain a highly rated investment will thereby be better off and essentially more satisfied with an investment chosen in the socially integrated optimal portfolio model than with the value-neutral conventional counterpart. The suggested meta-model is indented as an encouragement for investors to also consider their personal values in investment activities and to evaluate whether a responsible investment will provide them with an improved investment holding.
Investing as if People and Planet Mattered 363 Any individual has the right to choose his or her values; religiously, environmentally, socially – or even contra-responsibly, if preferred.
What all small retail investors could benefit from, however, is simply to become aware of their personal values: they might be positioned to benefit from a non-financial gain of a responsible investment, which in turn may significantly affect the ultimate level of satisfaction with their investment activities.
The road ahead: the role of education
Altering the norms of an entire industry is by no means simple. An essential key to implementing ethical considerations in the financial market is the education of financial professionals, regulators and teachers at the very beginning of the careers. The priority of what is taught in business schools worldwide plays a major role. Sadly, finance related courses with focus on sustainability concerns, moral conflicts or the human perspective are often simply not offered in a masters programmes in finance. The technical level of the education and a tight time schedule may be the cause, but the fact remains that many financial engineers will eventually have to cope with working on potentially complex underlying human perspectives, even in asset valuation. It is fundamental to understand such questions as: what is fairness in the financial market? How does market regulation seek to balance efficiency and sufficiently equal opportunities without compromising competition and the free market?
And what are fair and unfair advantages in terms of access to information?
It is likely to benefit the financial system as such to have both the industry as well as regulators equipped with an early understanding of the necessary conditions for an efficient capital market, the often considered theoretical ideal. The theory of financial contracting includes the question of agency theory that concerns conflict of interest and the respect of confidentiality. As the financial market grows more complex, it is of 364 Trust and Ethics in Finance ever increasing importance that this particular area be properly understood. Consumers often have no choice but to rely on official bodies that oversee competition in order to ensure that they are treated fairly by the various financial institutions. Stakeholders in the industry will all stand to gain from the inclusion of a basic moral code of conduct in the intricate contracting that exists. How else can we expect fund managers not to take advantage of the lax definitions of responsible investment, making it a value-generating advantage, when they have been taught in university that rational value-maximisation is the only virtue?
If we consider the financial crisis, ethical aspects of selling practice and financial advice also play a key part in the future development of a healthy financial service sector. The integrity of complex financial products is extremely difficult to guarantee by regulation alone, simply because of their perplexing nature. It is necessary for financial institutions themselves to have a solid understanding of the potential moral conflicts that exist in their line of business. Along with the suggested educational input, morer research on ethical issues in neoclassical finance theory is also essential.
Twenty years ago, Horrigan (1987) already gave a clear Kantian analysis of the most frequent assumptions that exist in many areas of finance. He found clear scenarii of system break-down in several cases.
He proved the need for ethics not only within the subjects of qualitative corporate finance but also for the quantitative scene. Since that analysis was made, the complexity of the financial market and pricing models has increased exponentially. Yet they still build on the same underlying norms and values; an observation that only enhances the relevance of Horrigan’s study.
People and planet matter This article aimed to demonstrate two important ways of implementing ethics in finance; portfolio allocation of the small retail investor with Investing as if People and Planet Mattered 365 preferences for responsibility, and the education of future finance industry stakeholders. We put forward the idea that the financial crisis provides a unique opportunity to engage the general public in an informed, value-based choice of investments as well as to promote awareness of the implications of their investment activities. We also demonstrated that potential personal benefits from a responsible portfolio allocation can exist, and we can conclude that for the SRI industry to thrive, it is vitally important that responsibility is not reduced to a green stamp confered by a loose definition of SRI.