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July 02, 2011
Tracking Error, Benchmarks, and Sustainable Investment Performance
    by Robert Kropp 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 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 about the second part of his presentation, which focuses on SRI portfolio performance.

"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) characteristics."

"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 identify performance."

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 active manager."

"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 questions."

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."


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