Unpleasant arithmetic of socially responsible investment

In this paper, we aim to model the impact of the presence of socially responsible investors on asset pricing. We predict that the presence of ethical investors leads to partially segmented markets, and thus market portfolio inefficiency. Indeed, if some investors do not want to hold some assets because of their ethical preferences, the other investors, which want to invest in all assets, need to take into account total risk instead of market risk, because a part of the idiosyncratic risk is no more diversifiable. We demonstrate that an unpleasant consequence of SRI is that since investors refuse to hold all assets because of ethical considerations, "unethical" firms must be priced lower than other firms, to compensate conventional investors for not being able to hold the market portfolio. (C) 2020 Elsevier B.V. All rights reserved.