The Moral and Financial Conflict of Socially Responsible Investing

Who is responsible for corporations making socially responsible choices? Is it the CEO, the public, the government, or the investors? If an investor follows his conscience to invest in socially responsible companies, will he lose money, or does socially responsible investing pay off in the end? This article addresses these questions.




Photo: Mikhail Tolstoy




One of the most important tasks of a modern industrial society is the allocation of capital. It is absolutely essential that in a democratic milieu capital assets be allocated to benefit the majority of productive individuals. William J. Baumol, a leading political economist of the 1960s, has noted the following:

The allocation of its capital resources is among the most important decisions which must be made by an economy. In the long-run an appropriate allocation of real capital is absolutely indispensable to the implementation of consumer sovereignty (or of the more appropriate concept—public sovereignty—which takes into account all of the relevant desires of the individuals who constitute the economy).[1]

This article addresses the central question of public sovereignty of the capital markets wherein the public, and not bankers, decide the allocation. Is the current methodology of capital allocation taking into account all of the relevant desires of the public who constitute the economy? The debate centers on socially responsible investing (SRI). What is more important, morality or profitability, and are they mutually exclusive? Do corporations have a responsibility to the environment, to their employees, to the communities in which they reside that supersede the corporations’ responsibilities to investors? On the other hand, do investors have the responsibility of focusing on companies that have great socially responsible track records over corporations that fail on these records while seeking dividends and price appreciation?

While capitalistic markets are disproportionately focused on “profit at all cost,” few trends would so thoroughly “…undermine the very foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as they possibly can,” said the late Milton Friedman.[2] Likewise the late George J. Stigler noted the importance of capital markets’ regulation of behavior.[3] Both of these economists are Noble Prize recipients as well as coming from the Chicago School of Economic Thought giving even more substance to their comments. This latter comment remains as important today as when Stigler made the statement. Secretary of the Treasury Paulson on November 20, 2006 called for the U.S. to “rethink” governance rules to keep the U.S. capital markets competitive.

If we believe that American public sovereignty of the capital markets include ethical behavior with equal financial results, it is obvious that we are in serious denial with some radical change in business behavior required. Otherwise, we end up just like any other third world country.

Shareholder Wealth

More often than not, corporations today are expected to utilize the shareholder wealth model, developed in the 1950s, stated in terms of maximizing shareholder wealth. In general, such a model demands a large earnings per share (EPS) growth rate without any social considerations. Historically, this has not been the case. Corporations were at one time essentially privately owned as well as local in character. Consumers more or less assumed that the entrepreneur’s own morality was incorporated into the firm. If a corporation behaved poorly by a community’s standards, this firm often would be boycotted especially if a substitutable product or service existed. We still see a modest amount of boycotting, but it is almost solely confined to small businesses with consumer sales. It is perhaps unfortunate that one cannot invest in many of these small businesses and their potentially higher community standards.

This provincial approach all but disappeared with the rise of the modern public corporation by the 1920s. This divorce of ownership from control resulted in a new form of economic behavior as so clearly noted by Berle and Means in 1932.[4] In the opinion of many, one aspect today of this separation of ownership from control is excessive pay to executives, predominately through stock options, which encourages dominance of the EPS growth aspect at all costs. This obsession with wealth has further caused a major ethical issue of backdating of options, which appears to have become widespread among American corporations. The theft of stockholders’ funds in recent times appears to run into billions of dollars.

The magnitude of the ethical problem for American corporations can be noted by the statement from Transparency International (TI), the anti-corruption watchdog, While TI concentrates predominately on international business transactions and the corruption of governments, it is not solely derived from this perspective. Thus, on Monday, November 6, 2006, TI reported that “the U.S. has suffered a ‘significant worsening’ in the perceived levels of corruption.”[5] The U.S. fell from a ranking of the 17th least corrupt nation to 20th among the 163 nations reviewed by the Berlin-based organization with a score of 7.3. This score equaled those of Chile and Belgium. Indeed, it should be noted that both Singapore and Hong Kong are ahead of the U.S. on this critical issue. One concluding comment from The Financial Times stated that “For companies, thinking just in terms of compliance is not enough.”[6]

When corporations make heinous decisions in an attempt to attain a high EPS growth rate (such as Ford’s decision to produce the Pinto in the face of overwhelming evidence that the vehicle was unsafe), the government steps in to administer punishment. Such decisions become more opaque, however, when the ethical/moral issues are less explicit and difficult to quantify. A case in point is the mining industry. Although mining is necessary to gather production resources for a modern industrial economy, it also often damages the environment. Is it wrong to prospect for sources at the expense of the natural environment?

Through their demand for equity, investors can dictate what is most valued in world opinion. For example, if companies whose pollutants damage the environment see their stock prices plummet, the cost to such companies of converting to a more environmentally conscious operation would no doubt be offset by positive price appreciation in their stock accompanied by a reduction in their cost of capital.

Socially Responsible Investing (SRI)

In a capitalistic marketplace, the stockholders hold the “ultimate authority” over corporate conduct. Unfortunately, it is a “passive” ultimate authority. Due to the U.S. Securities and Exchange Commission’s unwavering support of corporate management in proxy matters (in the opinion of the authors), the only “ultimate authority” is the passive strategy of selling the underlying interest rather than trying to change the behavior of management. Another, more pro-active strategy would be to limit investments to companies meeting reasonable criteria for the concept of a Socially Responsible Investment (SRI). Yet another, even more pro-active strategy, is to have the SEC or Congress change the proxy rules. This may happen due to recent Federal court decisions questioning the SEC’s position on shareholders’ proxy rights and the difficulty of placing issues before shareholders at the annual meeting.

Socially responsible investments “to a large degree depends on the investor.”[7] While some estimate that the market for socially responsible investment (SRI) funds stands at $2.16 trillion,[8] the actual criteria used to define SRI are rather subjective. The Social Investment Forum lists 12 types of screens for company exclusion. These screens include the following industries or issues: alcohol, tobacco, gambling, defense/weapons, animal testing, product/service quality, environment, human rights, labor relations, employment equality, community investment, and community relations. Many believe that other screens need to be added such as ethical management. Needless to say, there will be no end to the debate dealing with the proper selection of screens for SRI.

Value Based Leadership (VBL)

Many individuals can reasonably disagree over some of these screens. Many individuals also believe that other screens need to be added. One of the most commonly suggested is Value Based Leadership (VBL). For example, companies found engaging in unlawful or immoral conduct, such as backdating options, should be rejected as an investment candidate until the guilty company is rehabilitated. In fact, the potential screening list can almost reach the point at which all companies must be eliminated. Hence, there is a real need to develop a consensus regarding the VBL definition. In fact, there is a real need for a consensus selection of companies that would become part of an SRI Index. Investment managers today basically develop their SRI qualified companies through internal analysis.

Finally, there is the problem of selective screening. Certain mutual funds also select companies based on other criteria. For example, the Aquinas SRI mutual funds invest in only those companies that reflect core Catholic religious values, while the Sierra Club mutual funds invest in only those firms that have positive environmental track records.

The securities markets are comprised of companies having vastly different moral and ethical track records. The concept being suggested here is the recognition of the Value Based Investor (VBI). If Value Based Investors exercised their financial power by encouraging social responsibility among corporations, then a large sum of investment dollars would flow from socially responsible investors, and a goodly number of mutual funds, investment companies, state retirement boards, and investment advisors would utilize screening techniques to isolate companies having high degrees of social and moral responsibility.

Amy Domini notes, “The way you invest can contribute not only to your bottom line but also to a just and fair society.”[9] Yet, overwhelmingly, mutual funds do not utilize any qualitative SRI screening techniques. Perhaps the multiple qualitative criteria make the concept difficult to market? Karin Grablin, a financial planner with Dictor Martin Investments, has stated that “…most clients are pretty much looking for performance, and they’re probably more geared towards that angle than social responsibility.”[10] Investment management firms that manage client assets and/or manage mutual funds for investors have a responsibility to their investors to maximize returns. Without returns, such firms lose clients. Their choices are as much about their clients’ well-being as they are about self-preservation.

Why do the majority of firms seem apathetic towards SRI strategies? It has been strongly suggested that such strategies are simply less profitable than non-SRI strategies. Then the ethical question also becomes, “What is more important—social responsibility or overall profitability?” We know that the Adam Smith “invisible hand” (individuals collectively will undertake the best economic choice) is not always correct from a moral position. Is the return differential between SRI strategies and non-SRI strategies minimal, or does the alpha (or excess return not accounted for in its beta, a measurement of risk) of non-SRI investments compensate society for the negative societal externalities produced by corporations that do not act socially responsible?

Modern Portfolio Theory (MPT)

Two contradictory schools of thought exist about how to construct a portfolio of equities to maximize shareholder return. Modern Portfolio Theory (MPT) suggests that SRI investments are inferior to non-SRI investments. As per MPT, there are two categories of risk in the marketplace: systematic, associated with the overall markets, and unsystematic, or specific risk associated with a specific sector, industry, or business.

Diversification is the process by which investors add additional non-perfectly correlated securities in such a manner that Security A can partially mitigate the unsystematic risk of Security B within a portfolio. Efficient capital markets reward investors for systematic risk, which cannot be diversified away, but do not reward unsystematic risk, which is easily diversified away in an efficient portfolio through the addition of non-perfectly correlated securities.[11]

While all this sounds complex, it is not. Every stock and industry has a different business risk. MPT suggests that you take one stock from one industry (like an oil stock) and combine it with another stock with a different business risk profile (like a plastic manufacturer). The stocks move in less than perfect tandem (non-perfectly correlated.) In pragmatic terms, an investor should have no fewer than fifteen stocks in their portfolio with no more than two stocks from any one industry. This will result in a good degree of diversification being achieved.

Investors who choose to limit available securities using qualitative, non-financial criteria limit their ability to achieve adequate diversification. Using our example above, an investor might be forced to use three stocks instead of two from a particular industry. This portfolio like SRI funds will then bear a substantial amount of specific risk versus non-SRI funds and should logically achieve lower risk adjusted returns. In addition, firms that choose to invest capital in costly social programs increase costs and operate less efficiently than do firms that do not. Therefore, not only do SRI funds limit their investment universe at the expense of adequate diversification, but they may also be selecting from a pool of inferior companies that have uncompetitive cost structures.

Stakeholder Theory

Modern Portfolio Theory and simple portfolio construction accurately describe the diversification inefficiency that SRI strategies bear, but do not offer any explanation of possible benefits that socially responsible policies create. In support of SRI investments, the other school of thought is Stakeholder Theory. “Stakeholder Theory….portrays managers as individuals who pay simultaneous attention to legitimate interests of all appropriate stakeholders, both in the establishment of organizational structures and general policies and in case-by-case decision making.”[12]

In Modern Portfolio Theory, all stocks are considered homogenous. Stakeholder Theory suggests that a firm’s management of internal and external relationships will have significant positive or negative effects on future profitability. For example, a social agenda that includes above-market benefits for employees will attract the best workers, thereby making that company’s human capital more productive. Positive interactions with the communities surrounding plants/offices will result in more favorable negotiating power with local government officials for profitable tax breaks and other contractual obligations. Positive goodwill from superior social agendas will result in long-run economic and financial success. While the pool of possible investments is limited by using subjective criteria, Stakeholder Theory suggests that the available pool contains superior investments. As investors randomly select companies from a smaller pool of possibilities, the higher quality of those companies in the smaller sample offsets any negative effects described by MPT.

Eugene Ellmen, executive director of the Toronto-based Social Investment Organization (a non-profit trade association encouraging SRI strategies located at www.socialinvest.org) says: “Some people have the impression that to invest responsibly, you have to sacrifice returns…it’s a misconception to say that SRI investing leads to underperformance.”[13] Unfortunately, there have been many studies that have questioned this statement.

A recent paper by Michael Barnett and Robert Salomon has generated signal interest about SRI performance. Their very insightful paper also sought to distinguish between various SRI criteria, identifying the effects of the various SRI screens. Barnett and Salomon tested all 12 of the accepted screening methods (noted above) for SRI funds, but specifically targeted the effects of singling out firms due to environmental policies, labor policies, and community relations.[14]

The study resulted in several interesting conclusions. One such conclusion states, “The relationship between the intensity of social screening and financial performance for SRI funds is curvilinear or U shaped.”[15]

  • Mutual funds that use all 12 criteria are nearly as successful as funds that use none. However, mutual funds that use a handful of criteria, or that periodically relaxed their assumptions around social responsibility, suffer.
  • Mutual funds that stick to their core values and use all 12 of the accepted social responsibility screens apparently are able to realize on a broader scale enough long-term value through positive relationship building as to offset any negative results from lacking diversification.
  • Mutual funds that relax their criteria and show a lack of discipline towards those core values only end up bearing the negative externalities of less diversification; those companies do not realize sufficient positive value from their socially responsible criteria.

It would thus appear that SRI investing is an “all or none” proposition. This also mitigates the fact that particular SRI screens work at different times. In portfolio management, growth at times does better than value, or the reverse, and many other examples are possible.

Barnett and Salomon found a statistically significant—though small—positive relationship between positive community relations and financial performance. Michael Barnett reports, “Funds that select investments for their portfolio based on community relations screening criteria will earn higher financial returns than those that don’t.”[16] However, the study also showed that positive environmental track record and positive labor relations screening resulted in statistically significant negative effect on returns.

The Calvert Mutual Fund (CMF) organization is one of the better known SRI groups with a long-term record. It is useful to compare their performance against an SRI benchmark, albeit one they created themselves. The Calvert Social Index today contains approximately 600 large capitalized companies. The index is constructed by taking the top 1000 companies by capitalization and then analyzing each company according to SRI attributes. It is from this population that Calvert develops its portfolio selections. The performance of these funds is indicative of the gap differential in constructing SRI portfolios against the market. The performance results of selected funds are as follows for the period ended January 31, 2007 as reflected on the calvert.com website.

Fund or Benchmarks One Year Three Year Five Year
Calvert Social Index 11.93% 8.05% 5.25%
Calvert Fund Equity/No load 11.06% 7.23% 4.43%
Calvert Fund Equity/Load 5.79% 5.51% 3.42%
Lipper Multi-Cap. Core 12.45% 11.49% 6.31%
S&P 500 Index 14.51% 10.32% 6.82%

Average Annual Returns (%) For Period Ending 1/31/2007
http://www.calvert.com/funds_performance.html. (no longer accessible).

It is clearly disappointing that the Calvert Social Index (a non-managed fund) underperforms its noted benchmark (Lipper Multi-Cap. Core) in all three periods as well as underperforms the S&P 500 Index (total return) in the same three periods. Likewise, it is disappointing that the other two Calvert funds (managed funds selecting stocks within the index) underperformed as well.

SRI investment returns face a return challenge that must be clearly noted. Recognizing the limited testing period and population, socially responsible investing does appear to provide less than optimal investment performance. It appears that investors are not signally sacrificing their investment performance if they use very stringent social responsibility criteria. The fact that SRI mutual funds involved in the Barnett and Salomon study have higher expense ratios on average than do non-SRI investments[17] could account for the difference. Those higher expense ratios could be the result of lower operating efficiency of smaller firms that operate in the SRI marketplace rather than the difficulty of managing the portfolios. Regardless, the negative relationship is in no way significant enough to dismiss the societal benefit of the socially responsible stock selection. Rather, it raises the question of why more investors are not allocating funds to SRI investments.

One of the original questions in this article is whether or not social responsibility or investment returns has the greater value. For the individual investor, SRI investments utilizing currently existing SRI mutual funds will on average under-perform non-SRI mutual funds, encouraging investors to avoid them. However, since much of the underperformance appears to be a result of transaction costs and fund management expenses associated with small funds, there remains hope if more investors demand such types of SRI as part of their overall portfolio construction. This orientation could alter corporate decision making by increasing the demand for stocks of corporations having social priorities and policies deemed by society to be ethical.

According to Karl Marx, history is economics in action. If investors demand an SRI orientation, then it will follow. It becomes clearly essential that Value Based Investors insist on investing in Value Based Leadership Companies. This could promote positive initiatives for ethical conduct in workplace relations, production, and the environment.

This article also creates a challenge for pragmatic portfolio managers. The Calvert (or like) Social Index does contain a significant population. Are there not portfolio managing techniques available to construct within the social index a sub-set of companies that can not only outperform the index itself, but can outperform the Lipper benchmark as well? If so, there would be far less reticence by investors to own such SRI portfolios.


[1] William J. Baumol, The Stock Market and Economic Efficiency (New York: Fordham University Press, 1969), 1-2.

[2] Linda S. Munilla, “Corporate Social Responsibility Continuum as a Component of Stakeholder Theory,” Business and Society Review, 110, no. 4 (2005): 371-387.

[3] George J. Stigler, “Public Regulation of the Stock Market,” The Journal of Business, April (1964): 117.

[4] Adolf A. Berle, and Gardner C. Means, The Modern Corporation and Private Property. (New York: Macmillan Company, 1932).

[5] Hugh Williamson, “U.S. Seen as Getting More Corrupt, Says Watchdog,” The Financial Times, November 7, 2006.

[6] Ibid.

[7] Brian Neill, “For Some, Conscience Leads the Way, Bradenton Herald (Bradenton, FL), October 3, 2006.

[8] “Socially Responsible Investing Trends in the United States,” Social Investment Forum, (1999).

[9] Domini, Amy L. Socially Responsible Investing: Making a Difference and Making Money (Chicago: Dearborn Trade, 2001).

[10] Brian Neill.

[11] Michael L. Barnett. “Beyond Dichotomy: The Curvilinear Relationship Between Social Responsibility & Financial Performance,” Strategic Management Journal 27, March (2006): 1101-1122.

[12] T. Donaldson and L. E. Preston, “The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications,” Academy of Management Review 20, no. 1 (1995): 65-91.

[13] Paul Brent, “Ethical Funds Gain Popularity,” Toronto Star, October 12, 2006.

[14] Michael L. Barnett.

[15] Ibid.

[16] Ibid.

[17] Samuel R William, “Fund Spy“, Morningstar Column, September 5, 2006.

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Hedging Strategies for Uncertain Times

It is important to understand the nature of alternative investment strategies and their risks before considering any action.

The following article describes the concept of hedge funds/alternative investments, many of the different strategies they employ, and their relationship to Modern Portfolio Theory. The next issue of the Graziadio Business Review will include a companion article that will consider alternative investments or hedge funds as an option for individual “Main Street” investors, including a look at the idea of a fund of funds and the construction of such a “fund” utilizing mutual funds. The Editors.

The name was famous — Sir John Templeton — a name synonymous with investment results and investment prudence. When Sir John recently revealed in the Financial Times that he was partially hedging his equity investments, it raised the question for many of whether other investors should follow his lead and partially hedge their investments as well. Along with other investment stars such as Warren Buffet and Sidney Glickenhaus, Templeton believes that the long bull market is over. None of them is forecasting doom, although Buffet is looking for a modest 7% total annual return with increased volatility, and Glickenhaus believes that after a sixteen year cycle of boom, we could possibly see a sixteen year cycle of readjustment.

This outlook, perhaps one of irrational pessimism, is interfacing with an increased belief of many investors that a bubble is about to burst. It is not clear what bubble is meant. The explosion could come from the Treasury market, the stock market, one of the bond markets, or the housing or mortgage market. There appears to be no end of possible financial crises. There is also the underlying fear of yet another 9-11 type incident.

Hedging As an Option

It is not surprising then that many Main Street investors want to hedge a part, if not all, of their investment portfolios. They have heard that hedging can create high returns in both good and bad markets. However, the important point to remember is that high returns come only at the expense of high risk.

In the classical sense, hedging is an attempt to earn a riskless return. An example of this would be to short futures on the Dow Jones Industrials and go long on the underlying Dow Jones Industrial stocks in the cash market under certain pricing characteristics. To do so would create a true arbitrage-hedged portfolio, which if positioned correctly, could yield a riskless return. Unfortunately, a riskless return centers on T-bill interest. This return is indeed free money, but not the rate most investors desire. Hence, there is a tendency to move toward more risky hedge funds.

Fund Performance History

The performance of hedge funds has been good enough to continue to attract attention by investors. A recent article in Barron’s dated July 28, 2003, reported on the performance of hedge funds and noted that during the twelve month period ended June 30, 2003, 80% of hedge funds tracked by CISDM did better than the 1.5% decline in the S&P 500 index. Over the three-year period ended June 30, 2003, the article reported that 97.4% of the hedge funds had better results than the 32.9% decline in the index. This very solid performance gives hedge funds a powerful attraction as an alternate investment for investors.

However, it was further noted that during the April-June 2003 period, with the S & P 500 index up 12.9%, only 137 funds–or 20%–outperformed the index. This poorer performance makes hedge funds seem less advantageous as an alternative investment, although this example covers a very limited time period. Numerous individuals have pointed out that in general hedge funds are far more powerful in a down market than in an up market. However, this is not necessarily the case when one reviews the many different categories of so-called hedge funds available to an investor today.

Hedge Funds Defined

The vast majority of what are called hedge funds today do not conduct classical investment hedge strategies. In fact, it should be noted that the hedge fund industry is itself trying to change the nomenclature from hedge funds to alternative investments. This is clearly a better terminology than the one now in use. One should soon see this title being employed with increasing regularity.

Currently, however, the more common term is “hedge fund.” A hedge fund is nothing more than an unregulated investment pool (not under Securities and Exchange Commission review) with no more than 99 accredited investors (one million in net worth, or $200,000 in income) doing “something.” It is estimated that there are well over 5,000 so-called hedge funds in the United States with almost $400 billion in assets. Clearly this is an investment alternative that cannot be ignored.

Investment activities of these funds are conducted using a number of investment strategies. There is no general consensus as to their investment definitions. However, some fourteen categories of strategies have been suggested. Within each category, there are considerable differences in style and objectives. Particular categories could be combined with others, and often are, for computation of results. Further, there are considerable differences in the amount of leverage (borrowed money) that is employed. One must therefore review carefully the characteristics of the hedge funds included in any category results. The fourteen categories are described below.

Hedging Categories

1. Dedicated Short Bias

This is a so-called “bear” strategy wherein the fund is continuously shorting stocks it does not own in anticipation of a decline in value. The fund will perform inversely to the market. Therefore, these hedge funds will have extreme results. If the market is going down, the funds will have very high positive returns. However, if the market goes up, they will have very high negative returns.

2. Value Long/Short Equity

This strategy is an attempt to short stocks perceived to be “overvalued” and to purchase stocks perceived to be “undervalued.” The beta of the portfolio is allowed to vary depending on the economic outlook, although a low positive beta is the norm. One could approximate the market return if the portfolio selection were outstanding. (Beta is a measure of the sensitivity of the portfolio to the S&P 500 index, which by definition has a beta of 1.00.)

3. Market Neutral Equity

This strategy is the classical equity hedge. Here the attempt is to be insensitive to the market and create a portfolio with a beta of zero at all times. A second objective is to significantly outperform the T-bill rate by some multiple. Many times this strategy is combined with the value long/short equity due to the similarities of the two strategies.

4. Market Neutral Arbitrage

This strategy involves being long and short by approximately the same dollar amounts utilizing arbitrage techniques. Convertible bond arbitrage is an example of this strategy. In this strategy the fund sells short the common stock of a particular company while going long on the convertible bonds of that same company under proper pricing characteristics. Many consider this an excellent type of a hedge with modest risk if properly executed. The difficulty is finding enough opportunities in a rather limited market without resorting to more risky subsets. Likewise, fixed income arbitrage is often included within this category.

5. Fixed Income Arbitrage

This strategy is an attempt to use the bond market in a variety of different strategies. One could sell short the bonds of a company perceived as likely to have its credit downgraded and buy bonds of a company perceived as likely to have its credit upgraded. One could also short bonds of higher credit companies and use the proceeds to buy bonds of lower credit companies in anticipation that the Bond Confidence Index will move towards 100 as it has recently done. In this situation, lower quality bonds will do much better than higher quality bonds.

6. Managed Futures

This strategy uses the futures market to construct a variety of transactions. This is clearly a speculative strategy inasmuch as one can borrow considerable funds to leverage big plays.

7. Emerging Markets

This strategy uses the international markets (usually stock) to engage in speculative behavior. It normally centers on shifting funds from one foreign emerging market to another. Since these markets have high volatility and wide directional swings, there are considerable money-making possibilities. One can guess wrong as well. For example, many funds purchased Russian government bonds because of their high yield just prior to the government’s defaulting on them.

8. Macro

This strategy centers on “a top-down approach” more than anything else, with an intermediate time frame that is normally less than a year. Less emphasis is placed on individual financial assets than on a broad category of financial assets. George Soros often has bet on currency fluctuations. The recent deterioration of the U.S. dollar versus the euro is a good example of this strategy because it gave significant profits to speculators who anticipated the exchange rate change correctly.

9. Event Driven or Special Situations

This strategy can cover a very wide number of activities. A modest risk example would involve purchasing shares in companies re-purchasing their own common stock on the open market. Another example would be to purchase shares in companies increasing their dividends because of the recent change in taxation. A more risky example would be engaging in arbitrage in companies involved in mergers. A much higher risk example would have been to buy shares in Union Carbide (just after the accident that unfortunately caused a high death toll at the chemical factory in Bhopal, India) on the belief that the market “overreacted” (at least financially) to the news. Finally, many would place the purchase of distressed (usually bankrupt) securities within this category.

10. Market Timing

The market timing strategy is conceptually quite simple. It is clearly short-term in nature and usually based on technical factors such as price, volume, or behavioral sentiment. The objective is to buy a particular financial asset such as the S&P 500, perhaps even heavily leveraged, with the anticipation that the asset will increase in value. Needless to say, the reverse is adopted when assets are anticipated to decline in value. Sector rotation would also be included as a sub-set within this category. Sector rotation involves switching among Fidelity-like industry-specific sectors based upon either financial or technical characteristics.

11. Sector Specific

This strategy is different from sector rotation. Here more emphasis is placed within an industry-specific sector, perhaps selling “overvalued” stocks and buying “undervalued” stocks. The two most popular categories appear to be technology and financial services. Other industry categories are also utilized. Indeed, any Fidelity-like sector could be utilized.

12. Opportunistic

This strategy involves a fund manager rotating among the above strategies dependant upon the outlook associated with the chosen strategy at a particular point in time. This strategy category, more than any other category, depends on the investment judgment call of the portfolio manager.

13. Aggressive Growth

This strategy centers on investing in stocks that have a high growth potential due to strong sales and/or earnings growth. An example is a sales momentum model wherein one looks at the trend of annualized sales increases. Standardized Unexpected Earnings (SUE) is another example. SUE involves buying/selling (or shorting) stocks in companies that have reported earnings above/below the statistical estimated deviation or above/below the statistical deviation from analysts’ estimates.

14. Other strategies

Anything one can think up involving a financial asset can be put into play. Indeed, one of the fastest growing alternative investment categories has not been reviewed in this paper. This is the Fund of Funds category. As the name indicates, this is in essence a (diversified) portfolio of different alternative investment (hedge fund) strategies. (The Fund of Funds category will be addressed in the second article in this series.)

Hedge Fund Results

It is not surprising, given the multitude of categories and styles of hedge funds, that the financial results are quite mixed and involve extreme ranges of performance. Since these hedge funds have performance incentive fees for fund managers, it is also not surprising that they have attracted a lot of qualified talent. Unfortunately, they have attracted a lot of con artists as well, not to mention a good number of failed stockbrokers who, unable to find other employment, have become “Hedge Fund Managers.” Hedge funds are the investment community’s equivalent of the Internet. One must seek out the “best play” among a wide number of funds, many of which are headed for listing in the potential web site “www.hedgefunds.bombs.” However, a good number of hedge funds will be listed in the potential web site “www.hedgefunds.winners.”

The fact that so many hedge funds have come and gone creates a statistical nightmare for financial evaluation due in part to survivorship bias. Compounding this difficulty in evaluating performance is the fact that some managers will terminate a losing hedge fund only to start up a new one in hopes of a better record!

Hedge Funds and Modern Portfolio Theory

Even sophisticated investment managers and consultants utilizing all of the Modern Portfolio Theory (MPT) tools confess to being frustrated with trying to understand and properly quantify the risk-return matrix of many of the hedge funds. The calculations are not difficult, but the statistics can be almost totally meaningless. This would be the case, for example, when the calculations are applied to an opportunistic-style fund manager. There is no reason to assume that the past has any significance or predicative power for the future in such a situation.

Modern Portfolio Theory, on the other hand, assumes a high likelihood of the re-occurrence of investment risk and outcome. For example, MPT shows there is a high probability that over a ten-year period small-cap stocks will outperform large-cap stocks, which in turn will outperform corporate bonds, which will outperform government bonds, which will outperform T-bills, which will outperform inflation. This kind of probability does not exist with hedge funds. There is no basis for believing in the existence of any reliable rank order. Any rank order is extremely time-dependent. A good number of these funds involve the exploitation of an investment anomaly or are based on a hunch. Anomalies and hunches can never be properly quantified. Hence, one must be cautious about the rank order of a manager within a category over the long-term. One buys the manger and hopes that the historical (favorable) risk-reward relationship will continue.

Buying the manager, as we well know, can be a disaster. Long-Term Capital (LTC) was a hedge fund with tremendous capability and resources. Funded by well-known names, as well as Wall Street brokerage money, LTC employed the very best, including Nobel Laureates with Ph.D.s in finance! LTC had many favorable MPT characteristics. However, even with all of this talent, knowledge and intellect, LTC created one of the greatest investment disasters of all times. It suffered losses so great that the Federal Reserve was afraid that LTC’s failure could severely hurt the entire financial market as a result of its multiple trades that were yet to be unwound. To avoid a financial meltdown, the FED rushed to provide the liquidity required. (The LTC hedge fund receives first place in hedgefunds.bombs.)

One key advantage of Modern Portfolio Theory is the concept of mean variance analysis. This concept centers on the reward (return) per unit of risk borne (standard deviation).

Table 1 shows particular MPT statistics for a group of hedge funds that are representative of the strategies listed above, although the categories are not an exact match. The statistics cover a fifteen-year period ending in 2002. For comparison, these funds’ performance relative to the performance of the S&P 500 over this period is also included.

Table 1: Relative Hedge Fund Performance
1988-2002

Category Average Return % Std Deviation Sharpe Ratio S & P Relative %
Aggressive Growth 18.3 18.3 0.9 129
Distressed 10.5 4.8 1.5 214
Emerging Markets 20.5 22.8 0.9 129
Income 11.8 4.7 2.1 300
Macro 18.0 15.4 1.1 157
Market Neutral – Arbitrage 4.9 5.8 2.2 314
Market Neutral – Securities 17.8 5.2 2.9 414
Market Timing 18.9 12.7 1.3 186
Opportunistic 21.1 12.9 1.4 200
Short Selling 5.1 22.9 0.3 43
Special Situations 18.4 9.3 1.7 243
Value 18.0 12.9 1.2 171
Van US Hedge Index 17.7 9.4 1.6 229
S & P 500 11.5 15.5 0.7 100
1) The Sharpe Ratio is the best-known Modern Portfolio Theory statistic. It is the return of the portfolio minus the risk-free rate divided by the standard deviation.
2) Data on US hedge funds are from Van Hedge Funds Advisors, Inc., one of the major advisors within the hedge fund industry.

Conclusion

The alternative investment phenomenon is of importance to investors. The fifteen-year result of all U.S. Hedge Funds as noted by the Van Hedge Index is impressive at 229% relative to the performance of the S&P 500. Investors are forced to take note due to this performance. Alternative investments are clearly far more difficult to comprehend and analyze than perhaps any other form of investment. They are, however, clearly appropriate for certain individuals as part of their investment portfolios.

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