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June 02, 2004
New SRI Index Optimizes Social and Environmental Performance and Controls Risk
    by William Baue

The KLD Select Social Index caters to institutional investors by underweighting companies with weak social and environmental performance instead of excluding them.

Yesterday, KLD Research & Analytics, a Boston-based socially responsible investment (SRI) research firm, launched a new SRI index that "optimizes" weighting of companies with stronger social and environmental performance, while also controlling for risk. The optimization technique addresses institutional investors' discomfort with the SRI strategy of screening companies in or out of indexes, a practice that conflicts with the institutional priority of diversification across the entire market of stocks.

The KLD Select Social Index optimization method overweights companies with high scores on KLD's social and environmental analyses, and underweights companies with low scores. The index does not add or delete companies from its universe of about 350 stocks drawn from the S&P 500 and Russell 1000 except tobacco stocks. KLD controls for risk by constraining the index to a tracking error (or deviation) of less than two percent from its benchmark, the Russell 1000.

"For the most part in the US, there has not been strong institutional interest in SRI indexes, largely because of institutional resistance to screening and institutional concern about risk exposure in traditional SRI indexes," said Tom Kuh, senior vice president for business development at KLD. "I think it's fair to say that a number of SRI indexes are essentially indifferent to risk--that is to say, they apply the screens to a universe of companies but do not build into the index as a parameter the risk that attends such a portfolio."

"We've structured the optimization to maximize exposure to KLD's social and environmental scores across the broad market, but we've done so subject to controls on risk," Dr. Kuh told

The idea of using optimization actually came from a KLD client.

"The first time we at KLD encountered optimization was in conjunction with the CREF [College Retirement Equities Fund] Social Choice account, which used the KLD Broad Market Social Index universe and optimized it to the Russell 3000 as a benchmark," said Dr. Kuh.

The recognition of the efficacy of optimization converged with a realization of market demand and internal innovation at KLD, which led to the creation of the Select Social Index.

"Increasingly over the last couple of years, KLD has been developing quantitative underpinnings for its social and environmental ratings because there has been increasing demand on the part of our clients for the kind of metrics that allow them to compare and differentiate companies," said Dr. Kuh. "That dovetails nicely with the application of the ratings in an optimization setting."

The most overweighted companies in the Select Social Index--those with the highest KLD social and environmental ratings--are General Mills (GIS), Wells Fargo (WFC), and Proctor & Gamble (PG). The most overweighted sectors are packaged foods, soaps and toiletries, and financial services. The most underweighted companies in the index are ExxonMobil (XOM), General Electric (GE), and American International Group (AIG), and the most underweighted sectors are electric utilities, integrated oil, and retail soft goods.

The optimization and risk mitigation strategies show promise of delivering competitive financial performance compared to other SRI indexes, according to a study by Northfield Information Services, a firm that provides quantitative analysis to investment managers. The study compared five US SRI indexes: the Calvert Social Index, KLD's Domini 400 Social Index, the FTSE4Good US Index, the US component Dow Jones Sustainability Index (DJSI), and the KLD Select Social Index. Caveats included the fact that the DJSI is a global index and hence extracting the US component skews the index, and the fact that the results for the KLD Select Social Index were based on a backtest.

Northfield found that the KLD Select Social Index produced the best returns, averaging .22 percent per month during the period from December 1, 2001 to November 31, 2003, though the study cautioned that return differences were not statistically significant.

"These results reflect the deliberate focus on controlling risk so that on the one hand, it seems there are benefits to investing in companies that have relatively better social and environmental records, and on the other hand, controlling risk also contributes to the outcome," said Dr. Kuh.


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