Case Studies in Financial Engineering

CASE 1

VICE OR VIRTUE

Sept 2014

VICE OR VIRTUE

KKK Bank is a financial institution specialized in asset management. On the 10th January 2008, Mr Carlos Freitas deposited 1M€ at KKK Bank. Mr. Freitas is a well-known human rights activist and manager of a small company, “Green World”, known by following strict social responsibility principles and the “corporate social responsibility”. On the 21st January 2008, Mr Freitas issued an order to his account manager, to pursue a discretionary management of his assets, but giving preference to investments in securities issued by companies following, in some sense, the principles of “corporate social responsibility”. On the 10th December 2008, Mr. Freitas headed to the Bank after realising that his portfolio had suffered massive losses (roughly 50%) and noticing that in his portfolio composition there were securities issued by companies in the sectors of Tobacco, Alcoholic Drinks and Military. Furthermore, some of these companies had common major shareholders with the bank. Mr Freitas complained to his manager, as in his opinion he made clear that the discretionary management should be restricted to socially responsible investments. Therefore, he intended to obtain a financial compensation for his portfolio losses and for the ethical behaviour in his portfolio management. The manager argued to the Bank’s Board that the investor did not demand the investments to be done exclusively in socially responsible companies. Furthermore, this concept was hugely vague and several social investment funds also invested (though in a limited degree) in securities issued by companies in the Tobacco, Alcoholic Drinks and Military sectors. Accordingly, in Mr. Freitas’ portfolio, the weight of these sectors was non-significant. Additionally, all portfolio changes were regularly reported to the investor, who also assessed periodically the composition of his portfolio through the internet and never exhibited any discontentment with it (though the “suspected” securities were already in the portfolio for long). Considering the information reported above, please answer to the following questions:

1) Did Mr. Freitas’ account manager act properly? Please comment.

2) Does the exclusive focus on socially responsible investments lead to a lower portfolio performance? Please justify properly (namely by researching the literature on the performance of this type of investments).

3) In which extent can the securities in the portfolio by used as an argument? Are

there socially responsible investment funds allowing for investment in securities in the Tobacco, Alcoholic Drinks and Military sectors?

4) What are the main features of the FTSE KLD 400 Social Index (DS: FTCK4SL). Please compare its performance to the S&P500 index (DS: S&PCOMP) in the last 3 years.

5) Lobe, Roithmeier and Walkshäusl analysed the performance of sin indexes in

the paper “Vice vs. Virtue Investing” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1089827). Please comment the paper and its conclusions.

In order to solve the case, please consider:

a) The MIFID, implement on the 1st November 2007 b) The Code of Financial Analysts Behaviour c) The Securities Code d) Other references considered as relevant, such as research on the performance

of socially responsible investments and data on these investment funds. Note: See also Friedman, Milton (1989), “The Social Responsibility of Business is to Increase its Profits”, Harvard Business School, ref. 1-371-106.