July 02, 2011
Tracking Error, Benchmarks, and Sustainable Investment Performance
by Robert Kropp
SocialFunds.com talks with George Gay of First Affirmative Financial Network about the performance
of sustainable and responsible investment portfolios.
Building on its experience of organizing the popular SRI (Socially Responsible Investment) in the Rockies
Conference since 1999, First
Affirmative Financial Network has been hosting the annual BaseCamp SRI series for the
last five years.
Steve Schueth, President of First Affirmative, described BaseCamp
SRI to SocialFunds.com as "five regional events a year, which are one-day mini-conferences. The
conferences combine education and networking. We invite investment professionals, asset managers
and analysts, nonprofits, and investors as well; anyone who is looking to use money in a
transformative way that improves society."
At the concluding conference of this year's
series, scheduled for July 14 in Chicago, George Gay, CEO of First Affirmative, will host a
two-part presentation entitled Black Tails and Transparency: SRI Portfolio Risk and Performance.
Gay spoke with SocialFunds.com about the second part of his presentation, which focuses on SRI
"The oldest measurable record of a valid benchmark for an SRI index
is the Domini Social Index, created in 1990," Gay said. The Domini Social Index is now called the
MSCI KLD 400 Social Index, which is described by MSCI as "a free float-adjusted market capitalization index designed
to provide exposure to US companies that have positive Environmental, Social and Governance (ESG)
"There's a high degree of correlation with the S&P 500 over this 21-year
period, with just a few outliers," Gay said. "Since its inception, KLD has outperformed, something
in the neighborhood of 60 basis points a year annualized."
"When you look at monthly
comparisons between KLD and the S&P 500 benchmark, the largest underperformance was nearly 500
basis points, and the largest outperformance was nearly 450," Gay said. He described the extreme
fluctuations as the result of tracking error, which his presentation defines as "a measure of how
closely a portfolio follows the index to which it is benchmarked…If portfolio performance is
different than the benchmark you are looking at tracking error."
"The social index
outperforms in rising markets, where growth types of industries are favored. Generally speaking, it
underperforms in bear markets where value types of securities are favored," Gay continued. "Because
you have this tracking error based on market cycle, whether SRI outperforms or underperforms
depends on where you start measuring and where you end measuring. When you look at a times series
for 21 years, you have a tracking error relative to the S&P 500 based on overweighting of growth
companies and underweighting of value companies."
Turning to the issue of benchmarks for
sustainable and responsible funds, Gay observed, "The S&P 500 is obviously a poor benchmark for SRI
equity funds, because nobody generates that much alpha on that big of a basis. What might be a
better benchmark for this particular model, when you look inside the portfolio components?"
In his presentation, Gay considers the Barclays Capital Aggregate Bond Index as an alternative
to the S&P 500. However, the BarCap Aggregate index contains Treasury securities, which, Gay noted,
were the only securities that went up during the financial crisis. Because most SRI fixed-income
mutual funds do not include Treasuries, Gay continued, "It isn't necessarily the best benchmark to
Gay's presentation concluded that the Russell Midcap Value Index,
which includes US-based mid-cap companies with lower price-to-book ratios and lower forecasted
growth values, is an adequate benchmark for sustainable investors to use when evaluating the
performance of portfolio managers.
Finally, Gay's presentation turned to the age-old
criticism of mainstream analysts, that evaluating companies on the basis of ESG considerations
reduces diversity and leads to portfolio underperfomance.
Arguing that every portfolio
manager reduces a universe of 5,000 companies to, for example, 50 companies for inclusion in a
portfolio, Gay said, "That's what everybody says they do. And for anybody except SRI, people claim
that that adds value, by winnowing out all those companies for various reasons. However, with SRI,
they say that winnowing out those companies because of SRI reasons is going to create
underperformance, for the same process that is alleged to create outperformance for any other
"The likelihood of those fifty names significantly outperforming or
significantly underperforming is pretty far out on the tails. It's statistically insignificant," he
continued. "Reducing the universe is something everybody does, and leads you to two qualitative
One of the questions—whether there is reason to believe that reducing an
investment universe on the basis of ESG factors leads to underperformance—is answered, according to
Gay, by a 2007 report from Mercer, which
concluded that ESG factors provide a "qualitative variable for consideration at the macro and micro
level, such as a proxy for good management, environmental management systems and positioning with
respect to governance and climate change risks."
"By applying ESG factors there's the
possibility of reducing exposure to certain risks," Gay said.
He also referred to a more
recent report from GovernanceMetrics International (GMI), which concluded "that
firms defined as leaders in corporate responsibility have lower idiosyncratic risk…companies with
better CSR (corporate social responsibility) records…tended to have higher valuations," and
investment analysis that makes use of ESG factors can be better positioned to forecast the
long-term performance of a company.
Raising a second qualitative question, Gay said, "The
only possible reason for underperformance if you apply social factors would be if the managers who
use it are poorer managers than anybody else. How do you conclude that the people managing ESG
strategies in their portfolios are qualitatively worse than everybody else?"
"What do the
SRI investors gain, and what do they give up?" he asked. "What they gain is tracking error, and
they don't give up anything on the performance side."