Ethics in Financial Markets
JC de Swaan

Princeton University
October 16th, 2013
AGENDA

Modern Portfolio Theory
Ethics of Investing

1
Risk and Return on Bonds Versus Equity
1926-2000
In annual %
Avg annual
rate of return
Security

Volatility
Standard devia...
Effect of Diversification on Portfolio Risk
Firm Specific Risk
σ – Standard

σ

Firm Specific and
Market Risk

Deviation

...
Efficient Frontier

E(rp)
Portfolio Expected Return
Efficient Frontier of
risky assets

Individual assets

• Efficient fro...
Traditional Investment Benchmarks
Type of Investment

Definition

Benchmark

Traditional Investments

Mutual funds

• Dive...
AGENDA

Modern Portfolio Theory
Ethics of Investing

6
Forms of Ethical Investing
Form of Ethical Investing
Socially Responsible
Investing

Shareholder Advocacy/
Activism

Impac...
Non-Traditional Investment Benchmarks
Type of Investment

Non-Traditional

Socially
Responsible
Investments
(SRI)

Definit...
Social Good Metrics – Examples
Organization

Metrics and definition

Omidyar Network

Make investments in for-profit compa...
Investment Performance
Type of Investment

Performance relative to benchmark

Hedge funds

• The average hedge fund manage...
Investing and Value Creation
Description
/ Example

Pros

Cons

Social
Value

VC
Private
Markets

PE/LBO
Small caps

Tradi...
AGENDA

Modern Portfolio Theory
Ethics of Investing
Appendix

12
How Do Mutual Funds Perform Relative to Their
Benchmark?
Study/Source

Findings

Wermers (2000)

Mutual funds have zero or...
How Do Hedge Funds Perform Relative to Their
Benchmark?
Study/Source
Ibbotson, Chen, Zhu (2011)

Stultz (2007); Kosowski, ...
How Do Private Equity Funds Perform Relative
to Their Benchmark?
Study/Source

Findings

Harris, Jenkinson, and Kaplan (Ju...
How Do Venture Capital Funds Perform Relative
to Their Benchmark?
Study/Source

Findings

Harris, Jenkinson, Used detailed...
How Do Socially Responsible Funds Perform
Relative to Their Benchmark?
Study/Source

Findings

Mercer and UNEP Finance Ini...
How Do Impact Investment Funds Perform
Relative to Their Benchmark?
Study/Source

Findings

IRIS: Catalog of generally acc...
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Princeton ethics in finance 2013 session 6 -- ethics of investing

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Princeton ethics in finance 2013 session 6 -- ethics of investing

  1. 1. Ethics in Financial Markets JC de Swaan Princeton University October 16th, 2013
  2. 2. AGENDA Modern Portfolio Theory Ethics of Investing 1
  3. 3. Risk and Return on Bonds Versus Equity 1926-2000 In annual % Avg annual rate of return Security Volatility Standard deviation Nominal Real Treasury bills 3.9% 0.8% 10.2 Government bonds 5.7% 2.7% 88.4 Corporate bonds 6.0% 3.0% 75.7 Common stocks (S&P 500) 13.0% 9.7% 408.0 E(rM) Source: Ibbotson Associates 2
  4. 4. Effect of Diversification on Portfolio Risk Firm Specific Risk σ – Standard σ Firm Specific and Market Risk Deviation Firm specific risk Market risk n – Number of stocks in portfolio Source: Zvie Bodie, Alex Kane, and Alan Marcus, Essentials of Investments; JCdS n 3
  5. 5. Efficient Frontier E(rp) Portfolio Expected Return Efficient Frontier of risky assets Individual assets • Efficient frontier represents set of portfolios that maximize expected return at each level of portfolio risk • These portfolios are efficiently diversified • Rational investors will choose portfolios on the efficient frontier since they seek to maximize returns for a given level of risk Minimum variance portfolio σ – Portfolio Standard Deviation Source: Zvie Bodie, Alex Kane, and Alan Marcus, Essentials of Investments 4
  6. 6. Traditional Investment Benchmarks Type of Investment Definition Benchmark Traditional Investments Mutual funds • Diversified portfolios of financial instruments (generally, only long) that are accessible to investors with small amounts of capital and highly regulated. • Capital can be redeemed at short notice. • Beat or match the relevant index such as the S&P 500. Hedge funds • Funds that use advanced investment strategies such as being both long and short securities, derivative positions and leverage, which are targeted at high net worth individuals and institutions. • Generate excess risk adjusted returns (alpha) that are uncorrelated to markets Private equity • Funds that make investments in or buy-out private companies using pools of capital from high net worth individuals and institutions, which is committed for a long period of time. • Generate excess risk adjusted returns (alpha Venture capital • Long term capital provided to startup firms and small businesses with perceived growth potential. • Leading firms provide managerial and technical expertise in addition to capital. • Generate excess risk adjusted returns (alpha
  7. 7. AGENDA Modern Portfolio Theory Ethics of Investing 6
  8. 8. Forms of Ethical Investing Form of Ethical Investing Socially Responsible Investing Shareholder Advocacy/ Activism Impact Investing Source: Premise • Investors screen out any investments in companies that could be deemed to be harmful such as “sin-industry” stocks (e.g. tobacco or gambling) – “do no harm”. • Large institutional investors wield power and can attempt to influence recipients of their capital in a positive way. • Investors in that category include: 1. Institutional investors that have a duty to be “publicly-minded” because of their size and their constituency. Here, investors often apply a check list of items to each of their investment, generally pushing for better corporate governance, including better transparency and greater alignment of interest in incentives. 2. Activitist funds that seek to improve the companies they are invested in. Investors typically push for strategy adjustments, M&A, operational improvements, and/or balance sheet optimization. • Investors have an explicit dual mandate in their investments, including both generating attractive returns and having a positive impact beyond financial returns. • Areas of targeted impact include a wide spectrum of sectors associated with the public good such as the environment, affordable housing, clean water, healthcare for the poor, primary education, and micro-finance. 7 JPMorgan, Monitor Institute, John Boatright.
  9. 9. Non-Traditional Investment Benchmarks Type of Investment Non-Traditional Socially Responsible Investments (SRI) Definition • Investments that identify undesirable companies to avoid investing in and preferred companies to invest in. Benchmark Metrics • Beat or match the • Various metrics – often screens relevant index to avoid “sin” investments. such as the S&P 500. • Common themes that are screened out include: tobacco, alcohol, firearms, and gambling. Impact Investments (II) • Investments that have a dual objective: 1. 2. • S&P 500 or • Social metrics include: relevant • Income/Productivity benchmark, with Growth Do social or many impact • Agricultural Productivity environmental good investment funds • Community Generate a positive accepting lower Development financial return than market • Capacity-Building returns • Environmental metrics include: • Sustainable Land use • Sustainable Energy • Energy/Fuel efficiency • Pollution Prevention & 8 Waste Management
  10. 10. Social Good Metrics – Examples Organization Metrics and definition Omidyar Network Make investments in for-profit companies as well as provide grants to nonprofit organizations. Emerging Markets: • Create economic opportunity for the base of the pyramid through access to capital Developed Markets: • Encourage individual participation in media, markets, and government Acumen Fund • • Non profit that supports various forms of entrepreneurship to address global poverty issues. Uses philanthropic capital to make rigorous investments (both debt and equity) that seek both financial and social returns. Impact investment VC fund targeting underserved needs of low income populations in Latin America. IGNIA • Case Foundation • • • Identify the desired social good at the outset to qualify as an impact investment The specific metrics used are of secondary importance Impact investors should speak the language of traditional investors in order to secure capital Rockefeller Foundation • • • • Advance health Revalue Ecosystems Secure Livelihoods Transform cities Zip Car • • Honest Tea • • • Reduce the number of cars on the road Originally conceived as a not for profit, later turned into a for profit company by private equity investors Reduce sugar consumption Organic Produce Fair trade suppliers 9
  11. 11. Investment Performance Type of Investment Performance relative to benchmark Hedge funds • The average hedge fund manager has added value in both bear and bull markets generating a pre-fee return of 11.1%, which consists of fees of 3.4%, an alpha of 3.0%, and beta returns of 4.7%.2 • Other studies show more mixed performance: Adjusting for nonsynchronous mark-to-market shows that hedge funds did not on average create value from 1994 to 2001 3 • Best performer among all asset classes. • Outperformance versus the S&P 500 averages 20% to 27% over a fund’s life and more than 3% annually. 4 Venture capital Non-Traditional • Mutual funds have generated zero or negative alpha after fees.1 Private equity Traditional Mutual funds • Outperformed public equities in the 1990s, but underperformed in the 2000s.4 Socially Responsible Investments (SRI) • European SRI funds showed no significant outperformance, while US SRI funds underformed.4 Impact Investments (II) • 77% of the 2,128 impact investing organizations contributing data to IRIS were profitable during their last reporting period. 5 Source: 1. Wermers (2000), 2. Ibbotson, Chen, Zhu (2011), 3. Asness, Krail, and Liew (2001), 4 Harris, Jenkinson, and Kaplan (July 2013), 5. International Journal of finance and economics (2012), 6. IRIS Data Brief (June 2013) 10
  12. 12. Investing and Value Creation Description / Example Pros Cons Social Value VC Private Markets PE/LBO Small caps Traditional Investing Public Markets Fundamental Large caps Market inefficiencies e.g. Quantitative Corporate Governance Focus Constructive Shareholder Advocacy/ Activism Strategic/ Finance Focus Forceful Hostile Screening Out Socially Responsible Investing Screening In Impact investing 11
  13. 13. AGENDA Modern Portfolio Theory Ethics of Investing Appendix 12
  14. 14. How Do Mutual Funds Perform Relative to Their Benchmark? Study/Source Findings Wermers (2000) Mutual funds have zero or negative alpha after fees Friesen and Sapp (2007) Dollar weighted returns for US mutual funds are typically lower than buy-andhold returns. Frazzini and Lamont (2008) Timing of capital flows matters for investor returns, and that average investor timing is poor. Richard Finger (Forbes 2013) 66%, 84%, and 58% of all domestic equity mutual funds underperformed against the S&P 1500 in 2012, 2011, and 2010 respectively. Five Reasons why Mutual Funds underperform their benchmark: 1. 2. 3. 4. 5. Poor Stock Selection / Excess Diversification Fees charged by fund managers Cash kept for customer redemptions Money Manager Psychology Taxes generated due to frequent short term trading 13
  15. 15. How Do Hedge Funds Perform Relative to Their Benchmark? Study/Source Ibbotson, Chen, Zhu (2011) Stultz (2007); Kosowski, Naik, and Teo (2007) Titman and Tiu (2009) Boyson (2008) Findings The authors decomposed their estimated pre-fee 1995-2009 hedge fund returns of 11.13 percent into fees (3.43 percent), and alpha (3.00 percent), and a beta (4.70 percent). The year-by-year results show that alphas were positive during every year of the past decade, even during the recent financial crisis. Hedge funds generate an annual alpha of 3% to 5%. Idiosyncratic positions provide better returns Smaller funds earn higher returns Aragon (2007) Superior performance for funds with the most stringent restrictions on redemptions Survivorship bias masks overall hedge fund performance Fung and Hseih (2004) Fung and Hseih (2007) Marginal return of investing in hedge funds has declined with the growth of the industry Baquero and Verbeek (2005) Fund flows chase superior past returns, while greater fund flows are associated with poor future performance. Naik, Ramadorai, and Stromqvist Alpha is still positive but has been steadily declining over time (2007); Zhong (2008) Fung, Hseih, Naik, and Ramadorai (2008) Dichev and Yu (2010) Skeptical view of hedge fund returns, finding smaller and only sporadic alpha; Deploying larger amounts of capital becomes progressively more difficult and chasing the same investment opportunities yields diminishing returns. The real alpha of hedge fund investors is closer to zero; dollar-weighted returns are reliably lower than S&P 500 and marginally higher than the risk free rate. 14
  16. 16. How Do Private Equity Funds Perform Relative to Their Benchmark? Study/Source Findings Harris, Jenkinson, and Kaplan (July 2013) • Robinson and Sensoy (2011) Higson and Stucke (2012) A key attribute of this study is the data is derived entirely from institutional investors (limited partners) using investment history for 1,400 private equity funds derived from the holdings of over 200 institutional investors. • Outperformance versus the S&P 500 averages 20% to 27% over the life of the fund and more than 3% per year. • There is no significant relation between performance and fund size for buyout funds. Top size quartile funds have the best performance although they do not differ significantly from funds in the 2nd and 3rd size quartiles. • Because private equity investments are illiquid it is, perhaps, not surprising that they yield investors some premium relative to investing in public markets. Buyout fund outperformance remains similar in magnitude using other benchmarks, such as the Nasdaq and the (small-cap) Russell 2000. Studied buyout fund performance using cash flow data from Cambridge Associates and validated its outperformance. 15
  17. 17. How Do Venture Capital Funds Perform Relative to Their Benchmark? Study/Source Findings Harris, Jenkinson, Used detailed data from nearly 775 U.S. Venture Capital Funds. Found that VC funds outperformed Kaplan (July 2013) public equities in the 1990s but underperformed in the 2000s. Extremely strong performance for mid 1990 vintage VC funds. Since 2000, the average VC fund has underperformed by about 5% over the life of the fund. An influx of capital into VC funds is associated with lower subsequent performance. However, the smallest VC funds (3rd and 4th quartile) underperform larger funds. Rin, Hellmann, The emerging consensus of recent academic research is that average returns of VC funds do not exceed Puri (2011) market returns. The net returns of the best VC funds are clearly very high, the median VC fund rarely beats the market, and the lower tail of the distribution can generate large negative returns. Additionally, returns do not account for systemic risk and lack of liquidity. Robinson and Higher ability Venture Capitals generate higher gross returns, charge higher fees and raise larger funds, Sensoy (2011) and thus end up delivering the same net returns to investors. Phalippou and Reporting bias: Funds that do not report to ThomsonOne have 5% lower performance than funds that do Gottschalg (2009) so Fund performance is inflated by avoiding acknowledging poor performing investments. Kaplan and Schoar Examines 577 VC funds raised between 1980 and 2001 and they report a mean of 17% and a median of (2005) 13%. The average VC fund did 1.21 times better than its respective public market equivalent (PME) benchmark while the median did 0.92 (or 8% worse). Also, there was a wide distance between high and low achievers. Fund Managers that outperform with one fund tend to outperform with a subsequent fund. Driessen (2011) Report a beta of VC funds is 2.7 which is higher than that of prior studies including Jones and RhodesKroft (2004) of 1.8 and Ljunqvist and Richardson (2003) of 1.2. Fund level alpha is not related to size but beta increases with size. Higher return of large funds is due to higher risk exposure rather than higher abnormal performance. Korteweg and Using a more recent and complete version of Sand Hill Econometric data they find VC funds generate an Soresen (2010) alpha of 30% and a beta of 2.8. 16
  18. 18. How Do Socially Responsible Funds Perform Relative to Their Benchmark? Study/Source Findings Mercer and UNEP Finance Initiative (2007) International Journal of Finance and Economics (2012) SRI investments performed as well as or better than non-SRI investments over half the time. European SRI funds showed no significant performance over relevant indices, while US SRI funds showed evidence of underperformance against similar benchmarks. Dowell, Hart, and Yeung (2000) Firms adopting a stringent global environmental standard having higher market values than firms defaulting to less stringent host country standards. The KLD 400 (a SRI index) has outperformed the S&P 500 over the last 20 years generating a 7.21% annualized return vs. a 6.66% from 9/30/1993 to 08/16/2013 Bloomberg (See chart below) KLD 400 (Orange) S&P 500 (White) 17
  19. 19. How Do Impact Investment Funds Perform Relative to Their Benchmark? Study/Source Findings IRIS: Catalog of generally accepted performance metrics that leading impact investors use to measure social, environmental, and financial success, evaluate deals, and grow the credibility of the impact investing industry. (IRIS 2013) • O’Donohoe, Leijonhufvud, Saltuk, Bugg-Levine, and Brandenburg (J.P Morgan 2010) • • • • 4,090 mission-driven organizations contribute data to the IRIS initiative. The organizations are spread out over 128 countries and have been in business for an average of 15 years. In aggregate, they serve more than 131 million clients and employ over 600,000 permanent employees. In financial terms, they have earned revenue of nearly USD 265 billion, while 77 percent are profitable. Determined return expectations of impact investors by instrument and region: • Developed market high yield corporate debt ( 0 to 5%) • Emerging market corporate debt (8 to 12%) • Developed market venture capital (15 to 20%) • Emerging market venture capital (12 to 15%) 18

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