By contrasting optimal portfolio strategies that enforce well-behaved weights and those that are ethically limited, we assist investors in three ethical investment applications. In Sharpe ratio analysis, we show no evidence of a performance cost for sin-free, carbon-free, or Shariah portfolios with optimal readjustment upon limited investing, despite the fact that, in the most extreme instance, Shariah investing removes almost 65% of common shares from asset selection. In every instance, we pinpoint the precise portfolio modifications required to avert an ethical portfolio performance expense.
introductory
The moral rules that distinguish between what is right or good and what is wrong or terrible are known as ethics. Reweighting portfolios from offending to non-offending firms/sectors, investors with public financial assets frequently pursue social aims beyond personal financial gain. According to Heinkel et al. (2001), down-weighting reduces business investment and raises corporate and sector costs of capital. Naturally, small portfolio performance fees encourage investors to make ethical investments. There is evidence of this ethical-investor calculation in experimental, focus-group, fund-manager, and risk-premia investigations (Pasewark and Riley, 2010; Lewis, 2001; Van Duuren et al., 2016; Luo and Balvers, 2017). Gompers et al. (2003), for example, ranked companies according to their environmental, social, and governance (ESG) characteristics. Nevertheless, a ranking of this kind need not coincide with the worries of specific investors. As an alternative, we examine business behavior that is most concerning to issue-specific investors in carbon-free, Shariah-compliant, and sin-free portfolios using a standard portfolio creation methodology. Of course, not every investor considers being “sin-free,” “carbon-free,” or “Shariah-compliant” to be a prerequisite for moral business practices. For instance, not all investors adhere to Shariah compliance due to its religious foundation. All the same, these are the most standard standards used by ESG investment managers.
The dramatic rise in demand for ethical investing is what spurred us to conduct this study. In order to meet ESG standards, professionally managed financial investments now need to be worth over $11 trillion in 2018, up from $3 trillion in 2010.One Even so, there is a lack of guidance about portfolio construction for both professional investment managers and investors due to the inconsistent empirical studies on the effects of ethical investment on portfolio performance (see the references below).
We think that inconsistent outcomes result from contemporary portfolio theory’s (MPT, Markowitz, 1952) shortcomings, which make it impossible to accurately evaluate the costs of ethical portfolio performance. Comparing morally restricted versus unconstrained optimum, practicable, and implementable portfolios is necessary for this measurement. Sadly, mean-variance analysis in MPT has a number of crippling application limitations, such as extreme long and short weights that fluctuate erratically over time, an unrecognized methodology for choosing a subset of common shares from the universe of common shares (to minimize the costs associated with portfolio monitoring: Merton, 1987), and a poorer performance compared to simple equal-weight (1/N’th) investing.Two Even with MPT’s elegant economic design, these application limitations make it difficult to measure the costs of ethical portfolio performance for investors and impede the research of investing. In addition to identifying these expenses, we also provide guidance to investors on how to avoid them, building on earlier work.
With a reasonable sub-set of available common shares, we use portfolio construction approaches that enforce well-behaved weights, and we outperform 1/N’th investment with both estimation-free and estimated ex-ante returns in Sharpe ratio3 analysis. Using a negative screen that eliminates some shares, we find common shares for ethical portfolios. Since positive screening (financial asset inclusion/overweighting based on good ethical qualities) is hard to perform consistently, negative screening is in accordance with industry practice. Positive ethical traits for entire organizations are harder to verify than bad ones. We quantify the performance cost of ethical investment through portfolio techniques that stem from equilibrium analysis, but are applied non-equilibrium with an undercurrent of market inefficiency. By using normative portfolio theory, we assist investors in building portfolios with economically sound weights. In the past, stock prices would have varied so that, in a composite, ethical and unconstrained investors, each would have maximized their individual Sharpe ratios with all N risky-assets in the asset universe if investors had followed this advice. Our inability to find this result points to inefficiency, with the typical disclaimer that either our modeling or the market are off.
