Embedding Ethics in Teaching Investment Management: Understanding Socially Responsible Investing
Jenny Gu, Lynn Kendall, Shawn Groves, and Fernando Arellano
University of Dallas
Introduction
Ethics has increasingly become an important arena of research and teaching in finance. In their 2004 report, the Ethics Education Task Force to the Association to Advance Collegiate Schools of Business (AACSB) International emphasizes the importance of ethics education, stating “At issue is no less than the future of the free market system, which depends on honest and open enterprise to survive and flourish.”
A prevailing theme that encompasses ethics as it relates to investments is what is referred to as socially responsible investing (SRI), an investment discipline that considers social, environmental, and corporate governance criteria to generate sustainable financial returns and positive social impact in the long run. Recognizing the need for students learning investment strategies to be able to apply ethical reasoning and to go beyond simply meeting legal requirements,1 in this chapter we highlight how this broader goal can be achieved under the SRI construct. It is vital in today’s global economy for investors to forward their financial goals, while following their own personal social values; SRI is the means for alignment of goals.
The emergence of SRI can be traced back to 1990, when the first SRI index fund, the Domini Social Index (DSI), was established. Investment decisions based on ethical standards by professional money managers, which began in 1990, have since been superseded by SRI in 2000. Institutional investment giants such as the Vanguard Group and the Teachers Insurance and Annuity Association (TIAA) now have SRI mutual funds. According to the U.S. Social Investment Foundation’s 2014 report, an estimated $6.57 trillion was invested according to SRI strategies, increasing by 76 percent since 2012. On a global scale, Harding2 emphasizes the importance of “sustainability” with respect to SRI and this is reflected by the Global Sustainable Investment Association (GSIA 2014), which reports that, as of 2014, $21.4 trillion was invested in the global sustainable investment market, up from $13.3 trillion in 2012. Teaching ethics is integral to an investment course these days, not only in a traditional investment management or corporate valuation class, but also in an investment management practicum course, such as the Student Managed Investment Fund (SMIF). Clinebell3 discusses how the concepts of social investing can be incorporated into an SMIF and discusses how to design and integrate SRI with the core finance curriculum and SMIF. In particular, he emphasizes that an SMIF can be a useful vehicle and great learning opportunity for students, for addressing the ethical investing issues faced by today’s complicated investment environment.
In the following sections of this chapter we will describe the SRI discipline and outline the history and growth of SRI from its early beginnings to the importance of SRI Index Funds in international markets. The next section will describe typical ethical issues encountered in finance classes, with suggestions for applicability to investment and portfolio management courses. We will then highlight ethics teaching strategies and advice for teachers. A comparison of SRI in the developed versus the developing world is then presented, followed by our summary and conclusion. Concluding this chapter, we provide a variety of suggested exercises and projects that can be used at either the undergraduate or graduate finance levels.
Investment as a Field in Management
SRI is defined by Sparkes:
“The key distinguishing feature of socially responsible investment lies in the construction of equity portfolios whose investment objectives combine social, environmental, and financial goals. When practiced by institutional investors this means attempting to obtain return on invested capital approaching that of the overall stock market.” (Sparkes 2002, 26–27)
SRI considerations typically include a firm’s corporate giving, diversity, and employee relations practices as well as labor rights. Investments associated with alcohol, gambling, military defense, nuclear energy, or tobacco, and factors perceived to damage the environment are generally excluded from SRI funds. Investors who follow SRI guidelines are not only focused on financial returns. They are also concerned about having a positive investment impact on the community, country, and the world. In general, socially responsible investments are divided into the following three levels: shareholder engagement, community investment, and screening.
First, the objective of shareholder engagement is to maximize long-term value. It has been recently focused on proactively monitoring and influencing those entities to make socially responsible corporate decisions. This powerful tool is helpful as it not only improves the sustainability initiatives of the company but also avoids potential social liabilities, that is, corporate decisions that could otherwise have a large detrimental impact on society. Shareholder advocacy could be accomplished by all means such as dialogue, filing resolutions for shareholder voting, educating the public, attracting media attention to the issue, and so on. All of these activities direct public attention to corporate issues and further give pressure on corporate executives and boards of directors to make ethical business decisions.
Second, according to Forbes,4 community investment has become the fastest growing segment within SRI, with more than $60 billion in managed assets by the end of 2013. Community investments help those underserved communities who have traditionally been denied access to traditional institutional lending by providing them low interest capital to generate both financial return and social return.
Third, screening could be further divided into negative screening and positive screening. Negative screening is a method of eliminating particular firms associated with products, services, or practices, which do not follow SRI standards (e.g., firms with unsafe products or those producing unacceptable levels of pollutants). Screening is an important step for investors endeavoring to put capital to work for good. Positive screening includes projects on environment protection or consumer protection, or projects that will promote religious beliefs or improve company employees’ human rights. These areas of concern are generalized as “Environmental, Social, and Governance” (ESG) investing. However, screening, no matter negative or positive, is only taken as the third level of SRI and screening alone has minimal impact without effective implementations of shareholder engagement and community investment.
The current goals and practices of SRI have evolved over time. We begin our discussion by describing the early history of SRI, moving to a description of modern SRI.
History and Growth of Socially Responsible Investing
SRI is not a new concept, but rather builds upon hundreds of years of Jewish directives to invest ethically and Halal- or Shariah-compliant investing based on the Qur’an.5 The original principles established social justice norms and avoided investments that were in conflict with these norms. These concepts were further developed in the 1770s in England by John Wesley, the founder of Methodism. Quaker immigrants from England brought similar principles to the United States. Early common principles across these various religious groups focused on avoiding investments in businesses associated with liquor, pornography, gambling, and weapons, with Muslims shunning these business as well as banking.6
It was in the politically charged 1960s in the United States, when the Vietnam War, equality for women, and civil rights were in the forefront of consciousness that modern SRI took hold.7 During the 1970s, environmental and labor-management issues became important SRI factors with events such as the first Earth Day and the Three Mile Island nuclear plant accident.8
South African apartheid became a major issue for investors, which included the Episcopal Church filing a social resolution on South African divestment. Owing to pressure from universities, states, and municipalities for U.S. corporations to divest their South African assets,9 South Africa suffered economic instability, ultimately resulting in the end of apartheid. In the 1980s, a number of mutual funds were formed specifically for socially responsible investors, where early screening was a simple avoidance strategy—no gambling, alcohol, cigarettes, or weapons.
Today, Islamic funds such as the Permal’s Alfanar Investment Holdings (in partnership with the Saudi Economic and Development Corporation) follow Shariah law by avoiding investments in firms associated with alcohol, pork, gold, silver, gambling, and tobacco. Mennonites use Mennonite Praxis funds. Evangelical Christians invest in funds such as the Timothy Fund and the Noah Fund. Roman Catholics invest in Aquinas Funds, Catholic Values Investment Trust for Catholics, and Schwartz Investment Counsel, following early 1990s investment guidelines from the National Conference of Catholic Bishops.
More recently, events underlying the global credit crisis in 2008, primarily a lack of financial discipline and focus on only a short-term perspective, have further emphasized the importance for sustainable investment.10 Harding provides two reasons why sustainable investment is necessary: (1) The financial crisis generated a new awareness for responsible investing and (2) “The imperatives of climate change are placing equally pressing demands on society and politics.” A term commonly used today, both in the United States and abroad, to describe socially responsible investment portfolio selection and management is ESG, an investing approach that considers environmental, social, and governance factors (GSIA 2014).
Companies have evolved from passively taking ethical decisions to more proactively participating in SRI.11 For example, SRI investors and funds have recently initiated proxy voting guidelines and engaged in proactive dialogue with companies. Also, Schneider12 notes that hedge-fund executives are for the first time beginning to express interest in fund of funds13 committed to social values-based investing principles.
Thomsen reports that a survey by Praxis Mutual Funds (associated with the Anabaptist church) shows that 80 percent of U.S. investors view themselves as religious and describe themselves as Protestant, Catholic, or fundamentalist Christian.14 Fifty-six percent of respondents say they would consider personal ethics in their financial decisions. And interestingly, more females than males indicate interest in making financial decisions consistent with their faith. Over the decade 1989 to 1999, assets in religious mutual funds, though small, rose faster than the U.S. mutual fund industry as a whole. LoBaido15 notes that faith-based investing, one important subset of SRI, enjoyed “unprecedented growth” in the recent decade, with 12.5 percent of professionally managed money invested on faith-based criteria with U.S. religious mutual funds managing more than $30 billion in assets as of October 2012.
Academic research on SRI is still in its nascent stage and empirical results are still quite inconclusive. For example, by using a sample of socially responsible stock mutual funds matched to randomly select conventional funds of similar net assets from January 1994 to March 2001, Bello16 finds that socially responsible funds do not differ significantly from conventional funds in terms of these attributes. In contrast, Derwall, Bauer, Guenster, and Koedijk,17 find that SRI produces superior performance over the 1995 to 2003 period, with control of market sensitivity, investment style, and industry-specific factors.
Socially Responsible Index Funds
The first SRI index fund was the DSI, established in 1990, consisting of 400 major U.S. corporations, comparable to the Standard and Poor’s 500.18 In addition to the commonly accepted exclusionary factors, Domini considered product quality, corporate citizenship, and a firm’s relationships with women and minorities. Luck and Pilotte19 found that the DSI outperformed the S&P 500 over their May 1990 through September 1992 study period, with a cumulative return of 7.56 percent above that of the S&P 500. Building on the success of the first SRI index fund, socially responsible index mutual funds are now commonly available and an important sector of the world’s financial markets.
Each SRI fund has its own goals and screening criteria, providing a wide range of options available to potential investors. The U.S. Forum for Sustainable and Responsible Investment (SIF) has summarized the SRI screening and advocacy criteria for each of the forum’s 160 mutual funds provided by U.S. SIF’s institutional member firms. Figure 8.1 summarizes the percent of these 160 funds screening on each of several product and policy categories. Governance issues include board issues and executive pay. Each fund has additional screening criteria that it may use; the specific criteria highlighted here are consistently reported and provided by U.S. SIF.
Figure 8.1 SRI mutual fund screening criteria summary
Source: Report on U.S. Sustainable, Responsible, and Impact Investing Trends. U.S. SIF Foundation, 2014.
Typical Ethical Issues Related to SRI with Examples
Ethical issues in SRI are wide ranging. Here we focus on the examples of ethical issues discussed in Investments and Portfolio Management classes. It is easy to point to recent headline-grabbing ethical failures in business and the most recent financial crisis to illustrate the issue for students.
Shareholder engagement includes efforts made by companies to engage with shareholders on a wide range of topics such as corporate governance, executive compensation, strategy, risk management, and so on. Between 2000 and 2002, the market was almost ruined by a series of significant scandals that unveiled the crisis in corporate governance and ethics. The telecom firm WorldCom overstated its profit by improperly classifying expenses as investments, which eventually caused the third largest bankruptcy in U.S. history. Another large case was Enron, which used notorious “Special Purpose Vehicles” to move debt off its own books to overstate financial performance.
Fraud cases usually take the form as revenue prerecognition, overstated assets, understated liabilities/expenses, misappropriation of assets, and so on. Other scandals include systematically misleading and overly optimistic research reports provided by stock market analysts. Analysts’ compensation has been more closely linked with the investment banking business of their firms, not the accuracy of their reports, and they have submitted exaggerated reports to boost the banking firm’s business.
Auditors, watchdogs, and consultants have been increasingly unreliable as well. Many years after Enron’s failure, auditors still cannot stop managers from cooking the books. For example, Tesco announced that its profit guidance for the first half of 2014 was almost 30 percent too high, and the spotlight fell on PricewaterhouseCoopers’ auditing practices. During the recent 2007 to 2009 financial crisis, auditors again were accused of failing to raise relevant red flags. One notorious example is that before Lehman Brothers’ demise, Ernst & Young’s auditor even failed to detect repurchase transactions that disguised the bank’s extremely high and overwhelming financial leverage. Another example is that America’s Federal Deposit Insurance Corporation sued PricewaterhouseCoopers for one billion dollars for not detecting fraud at Colonial Bank, which failed in 2009.
Insider trading is defined as the practice of trading on a stock exchange to one’s own advantage while having access to confidential information. In the United States and many developed countries, these practices are considered illegal, whereas in some other developing countries these practices may not be regulated or enforced.20 In the United States, Regulation Fair Disclosure addresses insider trading and was promulgated by the U.S. Securities and Exchange Commission (SEC) in August 2000.
Securities trading is regulated by the SEC, by other government agencies, and through self-regulation of the securities exchanges. Many of the important regulations have to do with full disclosure of relevant information for all securities. The changing landscape of trading arrangements and developments of new securities presents challenges in regulation. After the Securities Acts of 1933 and Securities Acts of 1934, the Sarbanes–Oxley Act came into force in July 2002 and introduced major changes to the regulation of corporate governance and financial practice.
The Sarbanes–Oxley Act requires corporations to have more independent directors, requires each CFO to be personally responsible for the corporation’s accounting statements, creates a new public oversight board, and prohibits auditors from providing various other consulting services to the clients, among other substantial provisions. Inside trading rules also prohibit traders from attempting to profit from inside information. Recent scandals have rocked the securities markets. Numerous proposals for additional regulation have appeared even before the costs and efficiency of Sarbanes–Oxley can be assessed.
Although the SEC requires officers, directors, and major stockholders to report all transactions in their firm’s stock, in reality, the definition of insiders is very ambiguous. It is hard to define if the company’s major supplier is an insider or not. For example, technically speaking, a supplier is not the insider; however, a supplier may deduce the firm’s prospects from significant change in orders.
Derivatives markets could also have severe corporate governance issues. As Warren Buffett said in the Berkshire Hathaway Annual Report for 2002, “In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
SRI in Portfolio Management centers on portfolio trading, therefore, ethics in trading is the initial ethics topic discussed in Portfolio Management classes. It includes the following perspectives: verbal agreements must be honored in trading, or there will soon be no parties willing to trade; trading can be viewed as a zero-sum game as shrinking commissions create more adversarial relationships; loyalties of buy-side traders and managers must be aligned with the client.
The Chartered Financial Analyst (CFA) Program sets a standard for developing the skills, standards, competence, and integrity of financial analysts, portfolio managers, investment advisers, and other investment professionals worldwide. It is widely considered the investment profession’s most rigorous credentialing program. In particular, the CFA Program has established a Code of Ethics and Standards of Professional Conduct (hereafter Code and Standards) that lays out guidelines of practice for investment professionals.21 For example, the CFA Program curriculum of Level II and Level III exams discusses SRI issues such as ESG risk exposure analysis, corporate governance valuation implications, and positive and negative SRI screen impact on portfolio style characteristics.
Despite all these typical SRI ethical issues, ethical cases could fall into some “gray area,” and their complexity and dynamism would impede the ethical decision making.
Ethics Teaching Strategy
It is relatively easy to discuss SRI principles as separate theoretical issues and individual cases as compared to discussing in a broader market context. In reality however, it could be a fuzzy case in the interconnected global financial market. A strategy for teaching SRI in the complicated investment markets is to discuss how SRI is implemented in security selection, asset allocation, and risk management in an integrated system of the company, community, country, and global market. Students should also consider market sustainability, that is, the long-term health of the financial market as a whole, since the sum of seemingly innocuous, isolated, and unrelated business decisions, when aggregated, can cause systemic risk and market crisis.
In teaching investments, examples of specific ethical situations that an investment professional may encounter were evident during the much-discussed 2007 to 2009 credit crisis. Relying on financial structures, banks developed instruments that extended extra credit to consumers and companies. Clients purchased these financial instruments in a quest for yield in a low-interest-rate environment. When those higher-risk borrowers could not afford the loans, defaults soared and instruments collapsed. Investment professionals should have considered with greater foresight the question of market sustainability in tandem with the needs and expectations of the clients.
In teaching portfolio management, the key element is to help students involved with the SMIF to intuitively develop real-world experiences of investment research/analysis. In this way, students learn asset allocation and portfolio management in a complicated ethical investment environment. Portfolio management is based upon a body of knowledge such as quantitative methods, economics, financial statement analysis, corporate finance, stock valuation, bond valuation, derivatives and alternative investments instruments, strategic and tactical asset allocation, and performance evaluation and rebalancing. Based on the complexity of the material, ethical values are not always incidental to the profession of investment and it should be analyzed case by case in a discretionary manner.
In addition to a traditional SMIF, an SRI SMIF prepares students to gain experience in screening using ESG and become aware of the issues on shareholder advocacy and community investing. The discussion, and sometimes even debate, on whether companies are socially responsible will greatly enhance the student understanding of SRI and raises their awareness of ethical investing.
Advice for Teachers
New challenges will continually arise for students as ethical dilemmas are vague and difficult to distinguish. The conclusion as to whether actions are either right or wrong can be fairly difficult to determine. Ethical dilemmas are not simply black and white, and many cases could be ambiguous. Teachers need to discuss these “gray area” scenarios in the classroom. In a dynamic context, even well-intentioned, ethical investment professionals can encounter unexpected circumstances tempting them to cut corners. Besides talking about ethical investment theories, other related topics such as behavioral finance, psychology, and relevant examples should be discussed in the class.
Finance is about creating value for stockholders in the long run, principally concerned with procuring funding, being profitable, and managing risk. In the process of trying to achieve these objectives, some managers at times may engage in unlawful or unethical behavior. Managers’ self-serving objectives (the principal–agent problem) may also result in the same types of behavior. Unlawful behavior is easier to identify than unethical behavior for the former pertains to laws and regulations that have been defined and are expressed in written form with prosecution and punishment. Unethical behavior that is not also categorized as unlawful pertains to values and customs. Transgressions of ethical behavior are not easy to define and there are few examples of specific and material punishments, and therefore SRI will be an ongoing yet important topic for students.
Students must understand that investment professionals face unanticipated yet complicated ethical dilemmas almost every day in their work. Training and practice, supported with sound and relevant principles of ethical conduct, will help them not only recognize ethical issues but also make appropriate decisions. Students must also understand that displaying high levels of corporate social responsibility (CSR) reflects well on a firm overall, not just in terms of a higher SRI rating for the corporation, but in terms of shareholder returns.
CSR is not a zero-sum game. Doing the right thing for workers (either local or in foreign countries) and their communities does not necessarily come at the cost of shareholders. However, taking advantage of workers and their communities in order to increase the short-term bottom line for a project will often result in a net loss to shareholders from potential bad press, higher hiring and training costs, and an overall lowering of the company’s good name.
Finally, it is also important to keep the teaching material and case examples revised and updated to ensure that they remain relevant to this sophisticated investment profession and representative of the “highest standard” of professional conduct. For example, during the financial crisis period, the fact that Lehman Brothers was rated as an “investment” grade bond even three days before their filing of bankruptcy shocked the entire world and cast doubt on the effectiveness of credit rating agencies. Discussions of these recent events in unethical investment ratings, financial product packaging and distribution, and outright investment fraud, help to keep students current in the dynamic financial markets.
Developing Versus Developed Country Perspectives
SRI in the Developed World
SRI develops in a financial market as the market itself develops. This progression was discussed in the previous “History and Growth of SRI” section. Different regions may have differing ideas on what constitutes the most important SRI issues. In this section we will review a generalized comparison of SRI in the developed versus the developing world, highlighting some interesting differences in SRI focus.
Over the past two decades (1995 to 2014), U.S. SRI assets have grown at a compound annual growth rate of 13.1 percent, representing over $6.6 trillion in assets in 2014, up from $3.7 billion in 2012 (GSIA 2012; U.S. SIF 2014). More recently, as of 2014 (U.S. SIF 2014), there is a movement toward fossil fuel divestment and the adoption of policies restricting firearms investments. Newer and younger investors ( millennials) are focusing on sustainable investing and investing in firms/ products that support the advancement of women and crowd funding as a tool for ESG investors (U.S. SIF 2014).
Table 8.1 summarizes SRI investment as a percent of professionally managed assets and the proportion of global SRI assets by region. European ESG, both in total dollar value and as a percent of total managed assets, far exceeds that of other regions, with Canada representing the fastest growth rate in SRI assets. Canadian investors, while representing a relatively small portion of global SRI assets, put over 30 percent of their professionally managed funds into socially responsible investments.
European SIF (EuroSIF) (2015) reports that the organization had two major policy wins in 2014: (1) The adoption of the Directive on nonfinancial and diversity disclosure, and (2) EuroSIF is working to increase the level of conflict mineral disclosure in the form of self-certification for importers of tin, tantalum, tungsten, and gold. The importance of sustainable investing in Europe is highlighted by the fact that nearly 60 percent of managed funds are designated as SRI.
Table 8.1 Proportion of SRI relative to total managed assets
Proportion of SRI to total managed assets (%) |
Proportion of global SRI assets (%) |
Percentage growth of SRI assets (%) |
||
2012 |
2014 |
2014 |
2012 to 2014 |
|
Europe22 |
49.0 |
58.8 |
63.7 |
55 |
Canada |
20.2 |
31.3 |
4.4 |
76 |
United States |
11.5 |
17.9 |
30.8 |
60 |
Australia* |
12.5 |
16.6 |
0.8 |
34 |
Asia23 |
0.6 |
0.8 |
0.2 |
32 |
Global |
21.5 |
30.2 |
100 |
61 |
Source: GSIA Review (2014).
*2014 Proportion of global SRI assets and percent growth of SRI assets includes both Australia and New Zealand.
The GSIA review report for 2014 states that Japanese interest in SRI is growing based on 192 of the nation’s financial institutions having signed the Principles for Financial Action for the 21st Century. This pact seeks to shift the greater society toward sustainability by increasing investments in sustainable assets. Despite the cited increase in interest, total SRI trust assets declined from ¥261.4 billion ($2.5 billion) in 2011 to ¥243.5 billion ($2.3 billion)24 in 2013, with more than 70 percent of capital being in investment trusts and international equity funds with the environment as the primary screening criteria. Areas where there has been growth include environmentally friendly real estate (¥3.0 trillion, $28.8 billion), community investing, and microinvestments (¥10.0 trillion combined, $96 billion). Microinvesting is a concept that values empathy for social projects over economic profit (JSIF 2014), and is a relatively new investing tool that provides both societal and monetary returns, more focused toward individual investors.
SRI in the Developing World
In the developing world, sustainable investment is growing as well. China’s first SRI fund was established in 2006.25 According to China SIF, two key elements of SRI in China relate to environmental concerns, specifically, carbon emissions as well as development of an inclusive economy, which reflect the basic ESG principles.
The Association for Sustainable and Responsible Investing in Asia (ASrIA) 2014 Annual Report provides a number of interesting key highlights of SRI efforts among its member countries. Table 8.2 summarizes the study’s key results. Total sustainable investments (for 2013) in Asia (excluding Japan26) total nearly $45 billion (United States). This represents an annual growth rate of 22 percent since 2011. It should be noted that while the growth in Asia is impressive for some countries, overall Asian SRI investments as a percent of total managed assets is less than 1 percent of the total for the region (Table 8.2).
According to ASrIA (2014), Asian SRI efforts center in the area of ESG issues these being primarily climate change, energy, and water security (52 percent of sustainable investment assets), followed by exclusion/negative screening, which represents 37 percent of sustainable investment assets. In Malaysia, Indonesia, and Pakistan exclusion/negative screening in Islamic funds represent nearly 100 percent of these countries’ net SRI assets. ASrIA includes assets identified as Islamic or Sharia-compliant as SRI funds, based on the exclusionary/negative screening factors used, which align with basic SRI/ESG fundamentals. ASrIA further reports that 62 percent of their member respondents stated that climate risk will be the most important issue in the next two years.
Table 8.2 Highlights of Asian SRI statistics (millions of US dollars)
2011 $ |
2013 $ |
Percentage of 2013 Asian (ex-Japan) SRI assets (%) |
Compound annual growth rate (2011–2013) (%) |
|
Bangladesh |
Na |
14 |
<1 |
Nm |
China |
1,535 |
1,729 |
4 |
6 |
Hong Kong |
7,328 |
11,329 |
25 |
24 |
India |
153 |
115 |
<1 |
-13 |
Indonesia |
595 |
1,142 |
3 |
39 |
South Korea |
6,288 |
8,426 |
19 |
16 |
Malaysia |
9,956 |
15,087 |
34 |
23 |
Pakistan |
427 |
505 |
1 |
9 |
Singapore |
2,967 |
5,660 |
13 |
38 |
Taiwan |
724 |
714 |
2 |
-1 |
Thailand |
14 |
20 |
<1 |
19 |
Vietnam |
Na |
195 |
<1 |
Nm |
Asia |
29,988 |
44,937 |
22 |
Source: ASrIA 2014 Annual Report, http://asria.org/
African SRI assets as of the end of 2011 totaled $229 billion, and the relative proportion of African ESG assets to total assets under management exceeded 35 percent in 2011, or 1.7 percent of all global sustainable investments (GSIA 2012). The most common SRI investment in Africa is ESG integration. Not surprisingly, South Africa represents the largest share of total African SRI assets.
Conclusion
The SRI discipline began hundreds of years ago and the origins of SRI were based on religious principles. Over the past half century, these early guidelines have evolved to encompass a broader context, including environmental, social, and corporate governance issues. The growth of SRI worldwide, as highlighted in this chapter, emphasizes its broad importance and relevance in investment management courses. Several of the typical ethical issues that are related to SRI include those involving poor corporate governance, fraud, insider trading, derivatives trading excesses, and a lack of transparency in financial reporting. The CFA Program advances the interests of the investing community by both establishing and maintaining high standards for fair and ethical business practices, which are vital to mitigating many of the ethical issues mentioned earlier.
SRI principles can be implemented in security selection, asset allocation, and risk management within the overall system from the individual company through the community, country, and global market. We suggest that SMIF should endeavor to promote SRI by encouraging students to put these principles into practice through real-world investments.
It is necessary to reiterate the importance of ethical investment. In SRI practice, investment professionals benefit all market participants, stakeholders, and stockholders, and lead to increased investor confidence in global capital markets, building “reputational capital.” In summary, ethical investing is a fundamental requirement of the investment profession.
Suggested Exercises/Projects
How to Apply SRI in Each Step of Investment Process
Case of University SMIF.
The mission of University SMIF is to enhance students’ academic pursuits in the study of finance by offering exposure and participation in investment research and portfolio management strategies. More importantly, the SMIF investment process promotes an ethical approach to investing through active participation in the management of the SMIF portfolio.
In addition to a traditional SMIF, an SRI-focused SMIF prepares students to gain experience in screening using the ESG framework and become aware of the issues on shareholder advocacy and community investing. The discussion, and even debate, on whether companies are socially responsible enhances the student understanding of SRI and raises their awareness of ethical investing.
It is well known that there are four important steps in an investment process: (1) defining an investment strategy/policy, (2) investment analysis, (3) security selection and portfolio construction, and (4) execution and performance valuation. Students should learn how to apply SRI within each step of the investment process in the real world.
Step 1: Investment Strategy Policy. Students start with a fundamental ethical understanding of the purpose of wealth. There is a significant difference between secular finance and ethical finance. In secular finance, the purpose of wealth is to gain power and influence, regardless of whether it is sustainable or green. For investors with ethical beliefs, students need to pursue wealth, which promotes shareholder advocacy, community investing, and ESG.
Sample Exercise #1: A broad discussion on ethical finance can be introduced here, such as “Could we have avoided the 2008 financial crisis if Wall Street and the financial institutions had followed ethical investments?” The 2012 financial crises in Europe raises similar questions as elements have been recurring. The same question could then readdress and reframe the issue: “Could Europe have avoided their financial crisis if they had followed socially responsible investments?” Given the increasing integration of global markets, these issues can be applied to current events in different countries.
Sample Exercise #2: As investors, individuals, and institutions would all like to beat the market and maximize financial return, and they would all like to pick “financially good” investments on instinct. There are many conversation points to launch into thoughts related to the idea that “while generating returns is undoubtedly a part of the financial objective of investment management, should those investors also simultaneously maximize social good or set social good as a secondary target?” Furthermore, when there is a conflict between the “financially good” and “socially good,” which one should we choose?
Sample Exercise #3: An Investment Policy Statement (IPS) can state that “All Fund Managers will abide by the CFA Institute’s Manual of Code of Ethics, the ‘prudent man’ rule and ‘fiduciary’ responsibilities as they apply to investment managers and professionals.” Illustrate the implications of the previous statement and how to apply this in the SMIF.
Step 2: Investment Analysis. SMIF students must exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions. All investment decisions must have a reasonable and adequate basis, supported by appropriate research and investigation. SMIF encourages students to follow the CFA® Code of Ethics and Standard of Professional Conducts, which is fundamental and critical to assure that each stock analyst is complying with relevant rules regarding acting with and promoting integrity, using reasonable care and judgment, and maintaining professional competence.
Act with integrity, competence, diligence, respect, and in an ethical manner with SMIF, prospective donors, colleagues in the investment profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of University SMIF above their own personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.
Promote the integrity of and uphold the rules governing capital markets.
Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.
Sample Exercise #4: SMIF students need to prepare and present the quarterly SMIF investment performance to the advisory board. To comply with SRI requirements, students should provide examples of how they avoid “Misrepresentation” or “Misconduct” during the process of preparing the SMIF performance report.
Sample Exercise #5: Demonstrate the “Suitability” of investment selection in the portfolio. More specifically, students can illustrate a case when a certain stock is financially beneficial to SMIF portfolio while rejected as it is not deemed as socially good.
Sample Exercise #6: Substantiate the “Due Diligence” and “Reasonable Basis” of investment decisions. SMIF students can discuss and evaluate whether it is good timing to purchase or sell a stock with focus on SRI requirements.
Step 3: Security Selection and Portfolio Construction in Domestic and International Environments. An SMIF avoids investments on alcohol, weapons, drugs, and defense-related companies. At the same time, an SMIF can promote those “green” investments that seek both financial return and social benefit such as environment protection, consumer protection, human rights, diversity, and so on. Through investment screening, the SMIF primarily invests in equities, mutual funds, index funds, exchange traded fund, and investment-grade corporate bonds. Foreign securities available for purchase on U.S. exchanges (e.g., American Depository Receipts, or ADRs) and ETFs that are consistent with the Fund’s investment objectives and diversification considerations can be permitted for an SMIF portfolio.
An SMIF cannot complete any transaction that violates the principles and risk analysis outlined in these statements including borrowing money, pledging assets, currency trading, and investments in bonds, hedge funds, collateralized mortgage obligations, and collateralized debt obligations. Negative screening excludes certain securities from investment consideration based on social and environmental criteria. For example, students have decided in the past to avoid risky, volatile, and opaque technology companies where there may not be a suitable basis to invest in those companies. Students also have avoided pharmaceutical companies with contraceptive medicines, companies that sell tobacco or liquor, and companies involved with gambling and defense contractors.
Sample Exercise #7: Provide examples of “Shareholder Advocacy” investments in SMIF, or how SMIF avoids any company not following Shareholder Advocacy. Specifically, measure a company’s shareholder engagement from its corporate governance (auditing committee and audit checklist), risk management, executive compensation structure, and so on.
Sample Exercise #8: Provide examples of “Community Investing” investments in SMIF, or how SMIF avoids any company that is against Community Investing.
Sample Exercise #9: Provide examples of “Green” or “Sustainable” investments in SMIF, or how SMIF avoids any company that is not “Green” or “Sustainable.”
Step 4: Execution and Performance Valuation. Each SMIF student is responsible for one or more sectors of investment where investment analyzes are not only driven by company-wide financial fundamentals, but also by industry-wide factors and Porter’s five competitive strategies. More importantly, critical thinking of ethics, the logical analyses, and ethical analysis, and the reasonable interpretation of information provided in SMIF education should prepare students to further pursue studies in finance. Cited by a few students in SMIF programs, the SRI experience with SMIF has significantly improved their understanding and application of ethical leadership skills.
The final part of the process, and often the most important one for professional money managers, is performance evaluation of assets and investments managed on a periodic basis. Investing has been typically focused on solely one objective, to generate the most wealth you can, guarded by the relevant applied risk constraints for those assets. With ethical emphasis, the performance valuation not only measures numerical investment returns, but also incorporates ethical performance valuation measures.
Sample Exercise #10: To provide the most exposure to real-world investment environments, students assume rotations in these 10 sectors in SMIF: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunications Services, and Utilities. Each sector has its respective performance evaluation and SRI requirements. The SRI considerations could be quite different across sectors. Compare and contrast the different SRI requirements across industry sectors, and incorporate SRI into performance evaluation.
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1 Ogunyemi (2015).
5 The Social Equity Group (2015).
6 The Social Equity Group (2015).
9 Donovan (2015); Hylton (1992).
11 Active versus passive investment management are widely accepted and used theories in investments. For example, in the textbook “Investments” (2013) by Bodie, Kane, Marcus, one of the most popular textbooks in investments, page 350–351, “Investors can choose the assets included in the risky portfolio using either passive or active strategies. A passive strategy is based on the premise that securities are fairly priced and it avoids the costs involved in undertaking security analysis.”
13 Funds of funds are mutual funds or hedge funds that invest in other funds. Funds of funds are widely accepted and applied in hedge funds. According to the textbook “Investments” (Bodie, Kane, and Marcus, 2013), page 919–920, one of the fastest-growing sectors in the hedge fund universe has been in funds of funds.
21 CFA Code of Ethics and Standards of Professional Conduct: www.cfainstitute.org/Translations%20of%20Code%20of%20Ethics%20and%20Standards%20of%20Pr/english_code.pdf. The Code and Standards advance the interests of the global investment community by establishing and maintaining the highest standards of professional excellence and integrity. The code is a set of principles that define the expected professional conduct of investment professionals, and the standards outline conduct that constitutes fair and ethical business practice. All fund managers will abide by the CFA Institute’s Manual of Code of Ethics, the “prudent man” rule and “fiduciary” responsibilities as they apply to investment managers and professionals. By mastering the code and standards as well as fundamentals of the CFA Program, students are well prepared to join the investment industry dedicated to promoting the highest standards of ethics and professional excellence for the ultimate benefit of society.
22 European data in the GSIA Review was collected by EuroSIF in collaboration with its national SIF members and other partner organizations. The markets covered in detail include Austria, Belgium, Finland, France, Germany, Italy, Netherlands, Norway, Poland, Spain, Sweden, Switzerland, and the United Kingdom.
23 Asian data is collected in 13 markets: Bangladesh, China, Hong Kong, India, Indonesia, Japan, South Korea, Malaysia, Pakistan, Singapore, Taiwan, Thailand, and Vietnam.
24 Yen to US dollar conversion done at $1 = 0.0096 Yen (December 2013 rate).
26 Asian SRI statistics in Table 8.2 are for all countries included under “Asia” in Table 8.1, with the exception of Japan, as Association for Sustainable and Responsible Investment in Asia (ASrIA) reports on the described developing Asian countries. Japan Sustainable Investment Forum (JSIF), reports its data separately.
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