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Socially Responsible Investments represent a subset of the investible universe and therefore restrict the number of investment opportunities available to an investor by definition (Geczy et al, 2005). The most direct consequence of this is that investors might not be able to diversify away all the idiosyncratic risk that they are not compensated to bear, on average (ibid). However, as is argued by Bello (2005), there is little empirical evidence that corroborates this theory and in fact the difference in terms of investment performance between SRI-restricted and other unrestricted funds as a result of diversification is not statistically significant. Therefore, a change of policy to one that precludes non-SRI investments will not impose significant diversification costs on the investor. Geczy et al (2005) quantifies the added costs as just a few basis points per month. An alternate consequence of restricting investments to only SRI-equities has to do with a funds overall sensitivity to market movements. Nakai et al (2011) specifically examine the case of fund performance in the event of economic downturns and conclude that SRI funds, by virtue of the fact that socially responsible companies typically have longer-term sustainable strategies, are relatively more resilient to economic shocks and are more likely to survive downturns than their non-SRI counterparts. While this lower sensitivity could work against performance during boom periods, resilience during downturns is a significant advantage (ibid). Other benefits include relatively lower litigation costs for SRI-firms, which could translate to higher returns for SRI-funds (Copp et al, 2010). The majority of empirical research on the subject indicates that SRI-fund performance is indistinguishable from conventional counterparts in terms of asset characteristics, long-run investment performance or degree of portfolio diversification (Bello, 2005). Indeed, even after considering reasonable transaction costs and adjusting for investment styles, SRI-funds perform on consistent terms with conventional funds (Gregory and Whittaker, 2007; Kempf and Osthoff, 2007). As pointed out by Phillips, Hager & North Investment Management (2007), however, an important caveat is that the costs of initiating the SRI program must also be considered before adopting such a policy. These costs include the costs of hiring consultants and other service providers and screening costs, among others (ibid).

Part B

1) 2) Question 2

As there are no restrictions in taking short positions and we can borrow and lend at the risk free rate i.e. we can invest in or can sell short the risk-free asset e.g. short-term government security. In order to compute the efficient set for (1) SRI and Non SRI Portfolio, and (2) SRI only Portfolio we use Propositions 1 & 2. Also as we are allowed to borrow and sell at the risk-free rate we can pick out a particular portfolio as being the optimum portfolio i.e. the market portfolio. Without really depending on the client’s individual investor Utility curve i.e. Separation theorem (Elton et al, 2010). In order to compute the tangency portfolio (market portfolio) we use proposition 1 whereby we obtain the weights for the portfolio by solving for the following system of equations;

Now to compute the efficient set that we face in the 2 cases we use proposition 2 whereby we first compute the Global Minimum Variance Portfolio (GMVP) and another arbitrary portfolio and then combine these two in varying proportions so that we can trace out the entire envelope(Efficient Set). According to most of the existing empirical literature available there seems to be no evidence of a significant difference in the risk adjusted returns of SRI & Non-SRI equities. A study conducted by Bauer, Kees and Otten in 2005 suggest that SRI only portfolios go through a catch up phase before delivering financial returns similar to those of conventional portfolios. Diltz(1995); Guerard(1997) and Sauer also concluded in their studies that there was no statistical difference between the returns of ethically screened and unscreened universes. Research conducted by Hamilton et al. (1993) and Statman (2000), Luther and Matatko (1994), Mallin et al. (1995) and Gregory et al. (1997) all of them don’t find any statistically significant differences between the returns of SRI only Units and Conventional Unit Trusts.

In our results though we find that on constraining our investments to SRI only equities our efficient set contracts and shifts to the left, which means that for the same level of risk we now have a lower level of expected return.

Also on comparing the risk adjusted returns of the two portfolios we can see that the SRI only portfolio underperforms the SRI & Non SRI portfolio. So based on this analysis and also keeping in mind the empirical literature, for our case in particular we wouldn’t recommend adopting the SRI only investment policy to the fund.

Part B-3

University X has a number of restrictions, including long positions only. Short-selling has received a lot of criticism due to its purely speculative nature, therefore many institutions (including University X) have short-selling constraint Firstly, variance was minimized and GMVP weights adjusted for short sale constraint were obtained. Secondly, by using solver to maximize mean variance and adjust for short –selling constraint we were able to obtain new portfolios on the envelope line. Tangency portfolio (whereby delta equals to risk-free rate) has expected return of almost 2% and risk of 5%. It is clearly less efficient than unconstrained tangency portfolio with 5.2% and 6.9% respectively. The slope of CML in unrestricted case is twice as high. Figure B-3

Figure B-3 shows that restricted portfolios have higher variance for a given return than unrestricted ones. It indicates the fact that diversification benefits are reduced, since University X’s endowment fund can be invested in fewer options. On the other hand short-selling arbitrage strategies are considered to be much more risky due to the fact that fund’s maximum losses theoretically can be unlimited whereas in long strategies one can only lose market value of the portfolio (Melkumian 2010). The returns (given the risk) are lower since we are no longer able to profit from short-selling operations. However in our model additional borrowing costs associated with short selling are not included which may bring our returns down. Short-sale restriction therefore may have less pronounced effect on returns.

Generally we discourage University X from imposing short-sale restriction for various reasons. Firstly, assuming that University X’s utility function can be characterized in mean-variance terms, there is a clear loss in efficiency. Secondly, according to our model if short-selling is banned then efficient portfolios usually consist of Non-SRI industries. This may contradict other proposed postulates.

Part B-4 According to modern portfolio theory funds should not under-diversify due to risk considerations (Willenbrock 2011). Thus one logical solution for University X is to impose additional constraint in order to reduce exposure to each sector. The short-selling constraint was also kept in our model. To implement this strategy solver was employed again. Mean-variance function (Theta) was set to be maximum, given no short-sale constraint (all weights to be positive) and 10% cap constraint (all weights to be equal or less than 10%). Yet again it is believed that University X’s function can be characterized through risk return function. Several portfolios which lie on the efficient set were derived. Figure B-4

Figure B-4 shows joint constraint portfolios compared to unrestricted model. Just as in previous part the risk-return efficiency of the restricted portfolio is lower than of unrestricted one. Returns are lower for a given level of risk. However one could argue that University X is highly risk averse and consequently exposure to risky assets should be capped. Comparing to previous part, the efficient set (if both restrictions applied) has more volatility but higher returns. If University X forgoes investing more than 10% in bullish industries, then returns are likely to fall as well as diversification benefits. In general, arbitrage strategies as momentum strategy could not be fully utilized if this constraint is applied (Wei-Shan Hu 2011). Also in this model most of the weights were assigned to non-SRI sectors and if our client insists on SRI restriction, this could pose additional problem.

Part B-5 In previous parts we assumed that we can borrow at risk free rate (0.01%). In real world this would be very unlikely (Hui 2004). Our bank would not be able to short-sale T-bills (i.e. borrow) at this rate. Although we still assume that it is possible to long T-bills (i.e. lend) at risk free rate. Figure B-5(a)

Figure B-5(b)

Figures B-5 (a) and (b) Show represent no risk-free borrowing constraint for all sectors and SRI only sectors respectively. The difference in the efficient sets compared to previous analysis is in Capital Market line (CML). It does not exist beyond Tangency portfolio. Thus potentially it is possible to

invest all in risk-free T-bills, in a combination of risky and risk-free assets (represented by CML line) and in a combination of risky assets (points on envelope line beyond Tangency portfolio). Figure B-5 (c)

Figure B-5 (d)

The same logic can be applied to a set with short-sale restriction and a set with no short-sales and weight cap shown in figures B-5 (c) and (d) respectively. Since University X is relatively risk averse (given proposed endowment management changes) it is advisable to utilize this model.

**6) Limitation of the analysis
**

The first limitation of a mean-variance optimisation approach sits on the measurement errors in data collection since historical returns are very noisy due to inter-temporal variability (Roll 1981). Therefore, to be more accurate we used a large sample (9 years) and estimated expected return based on the single factor model.However, empirical studies have shown that the sensitivity of a stock can be linked to a multitude of macro-variable. Therefore, to regress the sensitivity of a stock on solely the market movements will ignorethe other sources of correlation in stock returns. In addition, this model requiresto define the market portfolio but it can only be a proxy. The Fama French Rm-Rf factor does not include all US stocks but only the ones included in either NYSE, AMEX, or NASDAQ. Therefore, the aggregate market benchmark will be less efficient, since less diversified than the true market, even if they are highly correlated (CFA Volume4). This can have serious consequences when testing the CAPM and particularly for evaluating portfolio performances, Roll (1981) referred to this problem asa benchmark error. For example, this leads to overestimating the true performance of the manager and the slope of the SML and the Betas will be underestimated. All this because the market proxyis less efficient and has a higher variance. Another serious limitation is the VCV matrix, the one factor matrix has less measurement error than the sample covariance approach (Ledoit O. 2003). However, it cannot fully explain the covariance of return because of the idiosyncratic components. As a result, it still generates some extreme coefficients that lead to impractical weights for the optimal portfolio (E.G. short-selling 80% of an index). This will not be possible to achieve in the real world, plus when we restrict short selling (what is the case of most mutual funds) our optimal portfolio is constructed of only 6 out of 49 industries. An optimisation such as the shrinkage matrix could have been use to pull this extreme covariance values toward more central ones and get more realistic weights (Wolf M. 2003).

Part c

1) Performance Analysis

It is striking how better are the performances of the funds derived from a mean-variance optimisation (P1 & P2) comparing to the two passive portfolios. However, their impressively high

expected return (over 2.5% monthly) need to be taken with cautious. As explained earlier some unrealistic investment proportions have been generated leading therefore to unrealistic performances. However, this still validates an important conclusion that an active selection out performs a passive one, which in turn also beat the market in our case. We can also see some parallels in the risk-return adjustment of the portfolios. The SRI funds P2 and P4 outperformed respectively P1 and P3 for all the measurement since having less risk for higher returns. However, the SRI funds have higher historical betas than the two others. This lead to smaller differences with the non SRI fundsfor the Treynor and Jensen ratios than shown by their counterparts that use a short horizon standard deviation.

2) Part C2

As was seen in the preceding section, the performance results of the funds are slightly inconsistent with what prior empirical research suggests. In terms of returns, the SRI-fund (P2) performs comparably with the composite unrestricted fund (P1). However, contrary to some prior research, risk levels for P2 seem to be significantly less than that for P1, which translates to a higher rewardto-variability ratio (Sharpe ratio) for the SRI-fund (P2). This could be because the SRI-fund, while being sufficiently diversified, has zero weights in a lot of industries for which the unrestricted fund sometimes has large weights. This would increase relative risk levels of the unrestricted portfolio. Another reason for the disparity between these results and other empirical findings could be because of the definition of what constitutes an SRI fund (Miskovic, 2008). Since there is no universally accepted definition of an SRI fund, empirical studies may not have used the same criteria as was used in the construction of P1 and P2, which could lead to different conclusions being obtained.

References

Bello, Z.Y. (2005) “Socially Responsible Investing and Portfolio Diversification”,The Journal of Financial Research, vol. 28, no. 1, pp. 41-57. Bauer, R., Koedijk, K., Otten, R. (2005) “International evidence on ethical mutual fund performance and investment style” Journal of Banking and Finance 29, 1751-1767. CFA Volume 4 (2009), “Corporate Finance and Portfolio Management”, CFA Institute, Pearson.

Copp, R.I., Kremmer, M.L. and Roca, E. (2010) “Should Funds Invest in Socially Responsible Investments during Downturns?”,Accounting Research Journal, vol. 23, no. 3, pp. 254-266. Diltz, J.D. (1995) “Does social screening affect portfolio performance?” The Journal of Investing 1, pp. 64-69. Edwin, J., Gruber, M., Brown, S. and Goetzmann, W. (2010) “Modern portfolio theory and Investment analysis” International Student Version. 8th Ed. Geczy, C.C., Stambaugh, R.F. and Levin, D. (2005) “Investing in Socially Responsible Mutual Funds”, [Online], Available: http://ssrn.com/abstract=416380 [15 March 2012]. Gregory, A., Matatko, J., Luther, R. (1997) “Ethical unit trust financial performance: small company effects and fund size effects” Journal of Business Finance and Accounting 24(5), 705-724. Guerard, J.B. (1997) “Is there a cost to being socially responsible in investing?” The Journal of Investing, 11-18. Gregory, A. and Whittaker, J. (2007) “Performance and Performance Persistence of “Ethical” Unit Trusts in the UK”, Journal of Business Finance & Accounting, vol. 34, no. 7-8, pp. 13271344. Hamilton, S., Jo, H., Statman, M. (1993) “Doing well while doing good? The investment performance of socially responsible mutual funds” Financial Analysts Journal 49 (6), 62-66. Hui, G. (2004) “Limited stock market participation and asset prices in a dynamic economy” Journal of Financial and Quantitative Analysis, 39, 495-516. Kempf, A. and Osthoff, P. (2007) “The Effect of Socially Responsible Investing on Portfolio Performance”, European Financial Management, vol. 13, no. 5, pp. 908-922. Ledoit, O. & Wolf, M. (2003) “Improved estimation of the covariance matrix of stock returns with an application to portfolio selection”, Journal of Empirical Finance, October 03, pp. 603621. Luther, R.G., Matatko, J. (1994) “The performance of ethical unit trusts: choosing an appropriate benchmark” British Accounting 26, 77-89. Melkumian, A.A. (2010) “The cost of short-selling constraint – welfare for investors under uncertainty” Applied Economics Letters, 17, 849-860. Miskovic, D. (2008) “The Definition of Socially Responsible Investing”, [Online], Available: http://www.responsibleinvesting.info/The-Definition-of-Socially-Responsible-Investing.html [16 March 2012]. Mallin, C.A., Saadouni, B., Briston, R.J. (1995) “The financial performance of ethical investment funds” Journal of Business Finance and Accounting 22 (4), 483-496. Nakai, M., Yamaguchi, K. and Takeuchi, K. (2011) “Are SRI Funds More Resilient towards the Global Financial Crisis?”, [Online], Available: www.econ.kobeu.ac.jp/doc/seminar/DP/files/1018.pdf [15 March 2012]. Phillips, Hager & North Investment Management (2007) “Does Socially Responsible Investing Hurt Investment Returns?”, [Online], Available: https://www.phn.com/portals/pdfs/Articles/20071012DoesSRIHurtInvestmentReturns.pdf [16 March 2012]. Statman, M. (2000) “Socially responsible mutual funds” Financial Analysts Journal (May/June), 30-39.

Wei-Shan Hu, J. and Yue-Chin, C. (2011) “The Performance of Momentum Investment Strategies: An International Examination of Stock Markets” International Journal of Management, 28, 165-176. Willenbrock, S. (2011) “Diversification Return, Portfolio Rebalancing, And the commodity return puzzle” Financial Analysts Journal, 67, 42-49. Wolf M.&Ledoit, O. (2003), “Honey, I Shrunk the Sample Covariance Matrix”[Online], Available:www.ledoit.net/honey.pdf[16 March 2012]. Wood, A. and McInish, T. (1985) “Bias From Nonsynchronous Trading in Tests of the LevhariLevy Hypothesis”, The Review of Economics and Statistics Vol. 67 (2/may) p. 346-351. [online] Available: http://www.jstor.org/stable/1924738 Melkumian, A.A. (2010) The cost of short-selling constraint – welfare for investors under uncertainty, Applied Economics Letters, 17, 849-860. Willenbrock, S. (2011) Diversification Return, Portfolio Rebalancing, And the commodity return puzzle, Financial Analysts Journal, 67, 42-49. Wei-Shan Hu, J. and Yue-Chin, C. (2011) The Performance of Momentum Investment Strategies: An International Examination of Stock Markets, International Journal of Management, 28, 165-176. Hui, G. (2004) Limited stock market participation and asset prices in a dynamic economy, Journal of Financial and Quantitative Analysis, 39, 495-516.

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