Navigating the Intersection of Finance and Ethics through Modern Portfolio Theory
Wall Street has long perpetuated the myth that socially, faith-based, value-based, or sustainable investing implies sacrificing financial returns while gaining a sense of moral satisfaction (Bhagat, 2022; Smith, 2022; Ashford, 2022; The Economist, 2022; Editor, 2022). Shannon Zimmerman (2015), an analyst at Morningstar, reported in August 2015 that “in roughly 60% of cases, funds that incorporated Environmental, Social, and Corporate Governance (ESG) delivered risk-adjusted results on par with or better than those of their average category peers.”
How can investors hedge their bets when making CSR investments? Is it possible to "do well by doing good" and profit with guidance from CSR ideals? How can they mitigate potential losses on CSR-based investments?
I would argue that diversification of investments provides a safe model for creating a profitable portfolio while still adhering to the principles of Corporate Social Responsibility.
Furthermore, I posit that shareholders have a duty to their families, communities, and religious beliefs by using money to enact positive change. Thus, investing becomes both a moral act and a fiduciary duty. Shareholders hold boards of directors and executives accountable by screening investments, voting proxies, and actively participating as shareholders.
Faith-based investing (FBI) involves incorporating Christian values into investment decisions. Investors must consider the ethical implications of their investments and exercise sound judgment when engaging in CSR.
As such, shareholders have a fiduciary responsibility to promote accountability, transparency, and the well-being of the firm's stakeholders. Without investor participation and collaboration, boards of directors and executives may lack accountability, risking the integrity of the investment process.
However, investors must not rely solely on the "warm glow" of CSR investing to generate profits while feeling morally gratified.
One strategy to reduce risk is diversifying investments, thereby mitigating risks through the Modern Portfolio Theory of investing.
Modern Portfolio Theory (MPT) posits that an investment portfolio carries both market risks (systemic) and firm-specific risks (Markowitz, 1952; Sharpe, 1964; Fama, 1971). According to MPT, investors can offset these risks by diversifying their portfolios across different securities. This theory led to the Capital Asset Pricing Model (CAPM) development by Sharpe, Treynor, Litner, and Mossin (Perold, 2004). Merton (1973) criticized MPT, proposing that the Intertemporal Capital Asset Pricing Model (ICAPM) offers a better explanation for the cross-sectional variation of equity returns (Petkova, 2006; Yuchao et al., 2015; Harjoto et al., 2015).
Modern Portfolio Theory (MPT) is integral to investors' decision-making process, particularly those incorporating elements of Corporate Social Responsibility and its subsets, such as Catholic Social Teaching (CST), Corporate Social Performance (CSP), Environmental Social Governance (ESG), Faith-based investing (FBI), and Socially Responsible Investing (SRI).
MPT was first developed in 1952 by Nobel Prize winner Harry Markowitz, who argued that investors can optimize the expected returns of a portfolio given a desired level of risk through diversification (Risk.net). Essentially, MPT aims to maximize returns for a given level of risk. Such investors are typically risk-averse and may not immediately recognize the benefits of CSR investments.
Socially Responsible Investing (SRI) employs negative investment screens to exclude certain firms, industries, and sectors, potentially resulting in higher firm-specific risks for the investment portfolio (Kurtz & DiBartolomeo, 1996; DiBartolomeo & Kurtz, 1999). Consequently, the portfolio may experience decreased risk-adjusted returns, according to MPT (Salomon, 2006). SRI also faces criticism for potentially violating its fiduciary duty to maximize returns for clients according to Modern Portfolio Theory (Markowitz, 1952; Martin, 2009).
Renowned economist Milton Friedman (1970) argued that Corporate Social Responsibility (CSR) contradicts Markowitz’s (1952) Modern Portfolio Theory (MPT) (Xiao et al., 2015). DesJardine et al. studied activist hedge funds, which perceive CSR as wasteful spending that hinders firms from maximizing shareholder value (2020). However, Vogel (2005) compared the returns of the KLD 400 Social Index with those of the S&P 500 between May 1990 and June 2004, finding that the KLD outperformed the S&P 500 (Avetisyan & Hockerts, 2014).
Current research on CSR, SRI, and ESG often lacks an understanding of ethical and professional standards and quantitative methods in finance. These knowledge gaps include MPT, the Global Investment Performance Standard (GIPS), and laws and regulations governing fiduciary responsibilities. Research is sometimes viewed from a subjective or objective perspective, but ethical investing should blend art and science while adhering to the guiding principles of the financial industry.
MPT is not without controversy. Its most significant criticisms argue that it evaluates portfolios based on variance rather than downside risk (Investopedia, August 29, 2023). Nonetheless, MPT remains useful for investors seeking to reduce risk through diversified portfolios (Ibid, 2023). For example, investors may mitigate CSR-related risks by investing in "safer" government bonds.
The argument is that investors can still aim to "do well by doing good," provided they know potential risks. Diversifying their portfolios can mitigate these risks without compromising the goal of CSR.
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