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November 12, 2003
Innovest’s Eco-Enhanced Portfolios Outperform Their Benchmarks
    by William Baue and Mark Thomsen

Contra Costa County Employees’ Retirement Association achieves both actual and simulated out-performance by tilting its portfolios using Innovest’s EcoValue21 ratings.


How does the application of sustainable and responsible investing (SRI) considerations affect the financial performance of portfolios? While many institutional investors ponder this question, relatively few have taken substantive steps to answer it through actual SRI investment, or through tracking the performance of hypothetical SRI portfolios. Last year, however, the Contra Costa County Employees’ Retirement Association (CCCERA) contracted Innovest Strategic Value Advisors to do both.

“CCCERA’s mandate was double barreled,” said Matthew Kiernan, founder and CEO of Innovest, a research firm that evaluates the environmental and social performance of over 1,200 publicly traded companies. Innovest compares these globally traded companies’ environmental and social performances to their financial performances.

“One directive was to work with Aeltus, an ING subsidiary, to construct and run real money in an eco-enhanced S&P 500 index portfolio combining Aeltus’ alpha strategies with our own, with the hope that two cracks at out-performance are better than one,” Dr. Kiernan told SocialFunds.com. “We prefer to leverage our partner’s expertise, so we integrated our algorithms directly into their model.”

Innovest’s proprietary EcoValue21 (EV21) environmental ratings account for approximately 20 percent of the weighting in the investment algorithm of this portfolio, which launched in March 2002 with $150 million.

“The eco-enhanced index fund is out-performing its S&P 500 benchmark by an annualized 15 basis points--not huge out-performance, but a lot better than under-performance!” said Dr. Kiernan.

“Perhaps even more interesting, Contra Costa also asked us to do a live simulation of the impact of adding an Innovest ‘tilt’ to the rest of their outside managers’ portfolios,” added Dr. Kiernan. “This provides an even ‘purer’ test, because the only factor added to the underlying portfolio was the Innovest overlay.”

CCCERA’s six external managers provided Innovest with the actual holdings in their portfolios as of December 31, 2001. Innovest applied its EV21 ratings to create simulated portfolios that ‘shadow’ the performance of the actual portfolios in real time, instead of back testing. Innovest rebalanced its tilts on a quarterly basis according to the managers’ rebalancing of their holdings throughout 2002.

“We overweighted the companies we had given high EV21 ratings to and underweighted companies that got low ratings,” said Hewson Baltzell, Innovest’s president. “We used a portfolio optimization model, which is something quantitative money managers use all the time.”

“Then we turned up the volume of our signal, the so-called ‘tracking error,’” Mr. Baltzell told SocialFunds.com.

Innovest cranked up the volume (or the “tilt” or the “tracking error”) by 50 basis points, 100 basis points, and 200 basis points for all six portfolios, thus creating 18 shadow portfolios. The actual portfolios covered diverse allocations: U.S. large cap growth, U.S. large cap value, international large cap, U.S. mid and small cap core, U.S. enhanced index, and U.S. large cap core.

“In five out of six cases, it helped to increase the volume,” said Mr. Baltzell.

For example, the U.S. mid and small cap core portfolio outperformed the actual portfolio upon which it was based by 51 basis points with the mildest volume increase, by 92 basis points with the middle tilt, and by 158 basis points with the strongest signal. The one underperforming shadow portfolio, the U.S. enhanced index, lagged its benchmark portfolio by 1 basis point, 4 basis points, and 40 basis points with the respective tilts. The average out-performance was 20 basis points for the mildest volume increase, 43 basis points for the middle tilt, and 82 basis points for the strongest signal.

“The bottom line is that five out of the six portfolios would have added performance, so we were able to go back to the county and say that it essentially left some money on the table last year,” concluded Dr. Kiernan.

 

 
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