Method and Data
In this section we will describe and give an account for the methods used in order to conduct the research. Section 3.1 will go through the capital asset pricing model and the Fama French 3-factor model. Section 3.2-3.3 describes the regression estimation procedure and data collection, 3.3 also includes description and summary of the data used in this thesis.
For the purpose of finding out the past performance of highly rated ESG integrated portfolios two main models will be used. The first one is the single index model of the capital asset pricing model (CAPM), which will provide the Jensen’s alpha4 as a performance measurement of risk adjusted return. The second one is going to be a multi-factor model which is the Fama French Three Factor Model, which also provides alpha as a performance measurement while taking other factors than the market-index into account. There are three possible hypotheses when it comes to the performance of socially responsible funds according to Hamilton, et al. (1993).
The hypotheses are denoted below:
H0: Expected returns of socially responsible portfolios are equal to conventional portfolios
H1: Expected returns of socially responsible portfolios are lower than of conventional portfolios
H2: Expected returns of socially responsible portfolios are higher than of conventional portfolios
Out of the four groups of theories mentioned in the theoretical framework one can draw conclusions on wheter they predict that corporations engaging in ESG issues receives positive, negative or no financial impact on firm performance. One might argue for that instrumental theories predicts that socially responsible portfolios performs worse than conventional portfolios, as their assets in form of shares in corproations are considered to deviate from the traditional goal of the firm of maximizing shareholder value. Intergrative and political theories are more based on the relationship between society and corporations in terms of responsibilities and dependency. Those theories might suggest that there is neither a gain or loss in financial performance but rather a responsibility for corporations to engage in ESG related issues. Ethical theories or more commonly known as stakeholder theory suggests that firms should take all stakeholders into account when conducting business practise to create a profitable environment at all levels of the firms operations, hence they predict a better financial performance from corporations engaging in responsible behavior.
The first model that will be used is the Capital Asset Pricing Model (CAPM) single-index model. The intercept which is denoted as α gives the Jensen’s Alpha, which can be interpreted as an under- or out-performance measurement relative to a market proxy. Jensen et al. (1972) states that the model lies under a certain number of assumptions, (1) all investors have risk-averse utility functions and are wealth maximizers and choose among portfolios solely on the basis of mean returns and variance, (2) There are no transaction costs or taxes, (3) All investors have homogenous views regarding the parameters of the probability distribution of all security returns, (4) All investors can borrow and lend at a given riskless rate of interest. In this report alpha will be used as an empirical way of assessing the marginal return associated with the ESG portfolios compared to their indices. The equation for explaining CAPM .
The left hand side of the equation denotes the excess return of the portfolio or security that is going to be evaluated. The right hand side of the equation denotes two sources of uncertainty and one performance measurement. rm – rf is the excess return of a broad market-index, i.e. the market return minus the risk free rate. βi denotes the systematic risk that the portfolio or security is exposed to compared to its benchmark, or the typical response in excess returns against the index’s excess return. αi denotes the alpha (Jensens alpha) that is explained in previous section as any risk adjusted return beyond the market index. The final term in equation (4) is the εi which represents the residual risk, with an expected value of zero (Bodie et. al, 2013).
Fama and French (1992) questioned the adequacy of only using a single-index model to explain movement in indices/stocks. The CAPM single index model seemed to fit in data during 1926-1968, but on data during 1941-1990 the relation between Beta and Stock returns disappears. Fama and French concluded that by adding two additional risk proxies, returns with regard to size and a book-to-market ratio variable one can explain cross-sectional variation in average stock returns more accurately. They found that average returns is negatively related to size and positiviely related to book to market ratios. This implies that smaller firms and firms with low book to market ratios are riskier than other firms. The Fama-French three factor model is explained through equation (5) below.
The left hand side of the equation indicates the excess return of the portfolio or the security against the risk free rate. Is the intercept or the financial performance beyond what the following three factors predicts. ( − ) denotes the systematic risk that the portfolio or security is exposed to compared to its market-index, or the typical response in excess returns against the index’s excess return. is interpreted as “High-Minus-Low” ratio, which is explained as a Book-to-Market premium or more explicitly the difference in returns between firms with a high versus low Book-to-Market ratio. denotes “Small-Minus-Big” ratio, which is explained as a size premium, or the difference in returns between small and large firms. The final term represents the residual risk, with an expected value of zero (Bodie et. al, 2013). The two extra factors in this model compared to the previous Single-Index model is based on the findings of Fama and French (1996) that most anomalies that are found using the CAPM model disappears when using a three-factor model.
HML and SMB variables are constructed in a two-step process. Firstly, size for any firm is defined once a year as the total market value of equity. Two groups are defined, one containing all stocks on the market in which the analysis is conducted that have a size larger than the median size of a stock. The second group is simply the stocks with a size smaller than the median sized stock. Then firms are broken into three groups on the basis of book value to market value of equity. The break points are the lowest 30 %, middle 40 %, and the highest 30 %. Thus 5 marketable portfolios are created. Returns for the market weighted portfolios in each of these five categories is then estimated. Secondly, the HML variable is made by using an analogous approach as the SMB variable above. It represents a series of monthly returns as the high book to market ratio minus the low book to market ratio stocks. By doing this one attempts to have the size variable free of both book to market effects and book to market variable free of size effects (Elton et al, 2011).
2 Frame of Reference
2.1 Theories of Corporate Social Responsibility
2.2 Theories of Traditional Finance
2.3 A Model on Investor Preference and SRI
2.4 Previous Work
2.5 Responsible Investment Strategies
2.6 Responsible Investment in Africa
3 Method and Data
3.2 Regression Estimation Procedure
4 Empirical Results and Analysis
4.2 Fama French 3-Factor Model
5 Conclusion and Discussion
List of references
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Responsible Investment: Should Investors Incorporate ESG Principles When Investing in Emerging Markets?