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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 ethical parameters • Define enterprise and fund ratings based on ethical criteria • 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 wi=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 wj Oij By changing wj and vj Subjectto Σ wj Okj <= Σ vj Ikj for each DMU k Σ vj Iij = 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 (see page 109-110)

  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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