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Socially Responsible Investing (SRI)

Socially Responsible Investing (SRI). Value-Based or “Ethical” mutual funds: Create screens to prevent investment in organizations that promote or participate in identified undesirable social, governance, and/or environmental actions or controversial business

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Socially Responsible Investing (SRI)

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  1. Socially Responsible Investing (SRI) • Value-Based or “Ethical” mutual funds: • Create screens to prevent investment in organizations that promote or participate in identified undesirable social, governance, and/or environmental actions or controversial business • May earn a lower return in the long term • Have higher diversification costs and thus can have more uncompensated risk

  2. Traditional Portfolio Measures of Performance (Risk Adjusted Return) • Sharpe Ratio: • (Return – Riskfree rate)/σ • Treynor Ratio: • (Return – Riskfree rate)/β • Neither can incorporate ethical factors

  3. Value-Seeking Investing • Since the late 1990’s, some proponents of SRI started focusing on identifying social and environmental criteria which effect a corporation’s financial performance and resulting share price • Screens are created to identify corporations that perform positively in these criteria, with the objective of maximizing the return of the portfolio

  4. Measuring Social Responsibility Level • Agencies and research institutes exist to: • Monitor, assess and classify companies and mutual funds on the ground of a set of social and environmental parameters • e.g. Kinder, Lydenberg, Domini & Company

  5. Data Envelopment Analysis (DEA) • A linear programming application aimed at evaluating the efficiencies of similar decision-making units (DMUs) based upon the inputs and outputs associated with the DMUs • A DMU is considered efficient if it gets the most output from its inputs • Efficiency is defined as the value of its outputs divided by the value of its inputs • The purpose of DEA is to identify inefficient DMUs when there are multiple outputs and multiple inputs

  6. DEA Applied to Socially Responsible Investing • Determines how efficiently a business (or fund) converts inputs to outputs when compared with other businesses (or funds) • This would allow an investor or fund manager to compare the efficiency of several competing funds or stocks • Outputs can represent the investor’s objectives: • To satisfy an ethical need • To obtain a satisfactory return

  7. Bank Branch Problem

  8. Efficiency of DMU i Weighted sum of DMU i’s outputs Weighted sum of DMU i’s inputs Where Oij=value of output j for DMU i Iij=value of input j for DMU i wj=weight of output j vj=weight of input j no=number of outputs nI=number of inputs

  9. Efficiency of DMU i Data Envelopment Analysis determines the weights to calculate the efficiency for DMU i: Wj = weight of output j Vj = weight of input j • W and V are Decision Variables in Solver! • Determines weight based on assumption that more of Outputs and less of inputs are desirable

  10. LP formulation for DMU i(where k = # of DMUs under consideration in complete set) Max Σ wjOijfor DMU i being studied By changing wj and vj Subjectto Σ wjOkj<= Σ vjIkjfor each DMU k Σ vjIij= 1 for DMU i being studied • DMUs whose objective values are <1 are inefficient: Combinations for other funds using the same weights wj and vj can produce the same or better output with the same or less input. • The LP will be run k times, once with each individual DMU as the objective

  11. Example Problem: Evaluating the performance of different bank branches • The profitability of retail bank branches is often determined by its loan and deposit balances • DEA identifies the weights for the loan and deposit balances that are the most complementary to the branch being evaluated • These ideal weighted balances are then compared to the balances at the other branches for those weights and rated on a scale of 0 to 1 for efficiency

  12. Excel Implementation • =Index(range, row number, column number) • Returns value in row number and column number of specified range • Use to automate process of running LP for many funds • Use VBA to program a loop that inputs relevant row number into the index function, run Solver, and record efficiency score or use RSPE’s parametric optimization abilities (see section 3.15.5 in 6th edition)

  13. Data Envelopment Analysis for Ethical Mutual Funds Outputs: O1j = Excess return for fund j O2j = Ethical measure for fund j Inputs: I1j = Risk measure 1 for fund j I2j = Risk measure 2 for fund j…. Inj = Risk measure n for fund j I(n+1)j = Cost 1 for fund j… I(n+m)j = Cost m for fund j…

  14. How would you incorporate the Data Envelopment Model into the Socially Responsible Investment process?

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