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 SocialFunds.com.
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
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.
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.
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.