1. Ethics in Financial Markets
JC de Swaan
Princeton University
October 16th, 2013

2. AGENDA
Modern Portfolio Theory
Ethics of Investing
1

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. 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. 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. 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. AGENDA
Modern Portfolio Theory
Ethics of Investing
6

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. 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. 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. 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. 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. AGENDA
Modern Portfolio Theory
Ethics of Investing
Appendix
12

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. 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. 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. 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. 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. 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%)
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