SRI Notes

John Templeton, Social Investor

It took a bit of hunting, but, finally, a decent obituary for Sir John Templeton, from The Economist. 

Warren Buffett has the star power, but Templeton was arguably an equally skilled investor.  Like Buffett, Templeton got his early training in securities analysis from Benjamin Graham.

When I was getting my MBA, my investments textbook listed four investors whose outstanding long-term track records were probably not due to chance:  Warren Buffett, George Soros, Peter Lynch, and John Templeton.

Of that group, only Templeton had any use for social investors.  He wrote in the late 80s that social investment funds "ought to be encouraged," and reportedly never owned a tobacco stock. 

For those who believe one must behave dishonestly or unethically to achieve superior investment returns, the career Sir John Templeton stands as a provocative counter-example.  For more information on Templeton in his prime, see John Train's excellent profile in The Money Masters.

Who Are These Guys?

A bit of a shock from Financial Times this morning:  "Large ethical companies consistently outperform the market, according to a survey of corporate social responsibility by Goldman Sachs, the investment bank."

Well, not really.  The report actually asserts that SRI indexes have historically underperformed, and offers this comment:  "one explanation for the historical relative underperformance of various SRI and/or ethical investment indices is the lack of integration with financial analysis". 

I'm sympathetic with the thought - social factors do need to be better-integrated with mainstream securities analysis.  But there's actually not much evidence to support what they're saying about performance.  Social investments haven't historically underperformed (for a long discussion of this see my 2005 Journal of Investing paper), and despite a rough three years the Domini Index is still ahead of the S&P 500 from inception.  If you're keeping score, it's currently Domini +12.1% (annualized return) vs. S&P 500 +11.5% from inception (5/90).  Major variations in performance appear to be explained by the Fama & French factors.  When you adjust for those factors, the big problem is explaining why the Domini index seems to have positive alpha. 

[Non quantitative readers can skip this note.  But if you're quantitatively inclined you can do your own analysis of the Domini numbers using the Fama & French factors from Ken French's website.  William Bernstein gives excellent step-by-step instructions here.  If you're in business school, ask your finance professor why the intercept is positive.  You'll get some interesting answers.]

The report is saying that certain companies Goldman Sachs likes have outperformed, and it introduces the GS SUSTAIN methodology to identify these companies going forward.  The report says that "our methodology is not designed to be comprehensive, nor is it designed to be prescriptive in judging what is good or bad practice."  (If you don't have access to Goldman research, this Associated Press article is a good backgrounder on the report.)

Peter Kinder has usefully divided social investors into three groups:

• Values-based investors - investors whose values drive portfolio construction with relatively little attention to the financial impact of those decisions
• Value-seeking investors - investors seeking to improve investment performance through the use of social or environmental variables
• Value-enhancing investors - investors that use shareholder engagement to increase shareholder value, but do not otherwise view themselves as 'socially responsible'

The Goldman report falls under the second heading.  They are not trying to make distinctions about what is right or wrong, or to serve a particular type of social or environmental investor.  The SUSTAIN project instead represents a serious effort to integrate stakeholder analysis with securities analysis, with a view toward improving investment returns.  That's a smart thing to do, and mainstream portfolio managers should take a hard look at it.

Turning the Page on the STAT Review

KLD has, after 16 1/2 years, decided to end publication of its Statistical Review of the Domini 400 Social Index.  A sensible move - the data's mostly available on the web now, and there are many social indexes at KLD and elsewhere for academics to work on.  Still, this was an important publication for a long time.

KLD's CEO, Peter Kinder, has written a brief note on this.  Congratulations to the folks at KLD who had the spirit and intellectual honesty to publish it for such a long time period, 'come what may'.  I think they can be proud of the results.

Update to sritudies.org

I've done my annual update on the sristudies.org bibiliography page.  Sorry, time doesn't permit a list of recent additions, but you can find them easily enough - just go to the web page, and using the search function in your browser (the "Find" command on the "Edit" menu in Firefox), look for "2006" or "2005".

One reason I've never put much directory functionality into sristudies.org is that Google is so powerful.  Try this - go to Google and type in:

site:www.sristudies.org 2004

That gives you a list of every instance of 2004 on sristudies.org.  When Google gets around to indexing the updated site (next week?  next month?) you can use this command to get a comprehensive list of more recent studies.

If you notice typos etc...I know, I know...anyone know a good proofreader?

Literature Reviews

A few weeks ago I was asked to give a talk on a paper I wrote almost ten years ago, "No Effect, or No Net Effect?" which reviewed the SRI performance literature up to that time.  The point of the piece was that neither proponents nor opponents of social investment could fully explain the performance we'd seen, which was about in line with the market.  Critics said there'd be a cost, and there wasn't.  Proponents said there'd be an benefit, and there wasn't.    A lot has changed since then, but I think that basic fact still stands.

Over the years I've written three reviews like this.  Most of the studies mentioned are listed at sristudies.org, with the notes I took when I reviewed them.  Here are citations for the reviews along with some links and comments:

Kurtz, Lloyd.  "No Effect, or No Net Effect?  Studies on Socially Responsible Investing."  The Journal of Investing, Winter 1997.

This was my first effort, and in 1997 not many studies had been done yet - this gave me some latitude to talk about theoretical issues.  A copy of this article is available online here.  It was summarized by H. Kent Baker for CFA Digest - he did a good job, and a copy of his writeup is available here.

Kurtz, Lloyd.  " 'Mr. Markowitz, Meet Mr. Moskowitz' - A Review of Studies on Socially Responsible Investing." The Investment Research Guide to Socially Responsible Investing, The Colloquium on Socially Responsible Investing, 1998. 

The publication of The Investment Research Guide to Socially Responsible Investing gave me an opportunity to update the original Journal of Investing piece, and to re-frame the basic issues raised by financial theory.  I feel this piece gives the clearest account of the duelling hypotheses of efficient market theorists and those who believe social factors improve performance.  It is available online here.

A lot has changed since those two reviews were written.  The research flow has gone from a trickle to a deluge, with dozens of new studies each year.  And, perhaps more importantly, the theoretical landscape has really changed.

Social investors used to have one clear opponent, those who believed in what we might call "strict CAPM".  This was nice because the debate was more-or-less bi-directional and could focus on a few key questions.  Today the debate is more complex - strict CAPM seems to have lost adherents, while Fama/French, Arbitrage Pricing Theory, Behavioral Finance, and even extreme skepticism have gained ground.  So conversations about SRI tend to be as much about the prior beliefs of the participants as the risks and benefits of applying social constraints.  My latest review reflects this, managing to be both longer and less coherent than its predecessors:

Kurtz, Lloyd.  "Answers to Four Questions."  The Journal of Investing, Fall 2005.

The one advantage of this piece (available here, but subscription only, sorry) is that it is pretty up-to-date, and touches on most of the important studies that have been done since 2000. 

But something very odd came out of this review.  Most of the studies in the areas of environment, employee relations, and governance seem to show positive results.  I don't know quite what to make of this.  The folks at Calvert think social screens help returns, and cite my tables in support of this idea.

But, as I say in the paper, I'm only partially converted.  Those tables are provocative, but when I look at actual SRI portfolios, I see performance that is similar to the market over time.  This suggests one of two things:  Maybe we're seeing a publication effect - only studies with positive results are getting into print.  Or maybe the effects are really there, but social investors aren't capturing them.

To get a definitive answer on that, someone with a lot of time and talent would have to do a meta-analysis of the SRI literature similar to the one Marc Orlitzky did with the corporate social responsibility literature.  Orlitzky found a weak but positive effect, and, importantly, showed that the publication effect would have to be enormous to alter his conclusions (hundreds or thousands of negative studies would have to have been ignored).

So, without evidence I'm free to offer an opinion: maybe both effects are in play.  Certainly it's easier to get a positive study published than a negative one, so the positive results are probably overstated.  But I think it's plausible that you can get an investment advantage from looking at environment, employee relations, and governance because all of these things logically connect with fundamentals.  Moreover, none of them is a focus of mainstream investment research. 

If I'm right about that, social investment managers should significantly outperform their competitors.  So why haven't they?

Good News, Bad News

Here is an interesting chart.  The KLD Social Select ETF (ticker "KLD"), which launched last year, is so far performing exactly as it is supposed to.  The benchmark it is based on, the KLD Select Social Index, is designed to closely mirror the performance of the Russell 1000, while maximizing exposure to companies with strong social and environmental records.

This chart shows that the KLD ETF has had performance virtually identical to an ETF designed to mirror the Russell 1000 (the iShares Russell 1000 Index, ticker "IWB").

The bad news, if you believe social responsibility pays, is that there's no outperformance so far.  Over time the performance of this product will be an important test of whether markets fully understand the positive financial benefits of corporate social responsibility.  So far, anyway, it looks like they do.

Vice is Nice, but Not Indispensable

I've had some questions about this December 14th press release from QED International, which states that social investors' aversion to vice industries has cost them returns.  I'll start with my critical remarks, but I also have some positive comments (down near the bottom).

Any time I hear about a study of historical returns, I have some basic questions:

Question 1:  Can I see the study?
Answer:  In this case the press release appears to be the study - there's no information on how to get a more detailed look at the work.
LK Comment:  There is a often a big gap between what the data shows and what the authors say it shows - if there's an underlying study it's good to have it.  In this case we'll work from the press release, which is pretty detailed.

Question 2:  Has the study been reviewed by anyone else or is it likely to be published somewhere?
Answer:  There's no mention of a more thorough writeup, nor of any attempt to have the work reviewed or published somewhere.  That doesn't mean it won't be, they just aren't telling you in the press release.
LK Comment:  It's a lot easier to write a press release than to publish an article in a refereed journal.

Question 3:  Does the study look at real portfolios, or backtests?
Answer:  Backtests (with the exception of Domini Index/ S&P 500 comparison).
LK Comment:  Hindsight is 20-20 - at any moment in time you can pick a group of stocks excluded by social investors that has performed well, and write an article about how social screens are costing investors money.  (For some reason everyone wants to talk about tobacco lately but not about the auto companies, which social investors have also avoided and which have underperformed badly in recent years.)

  Anyway, the real test of an investment strategy is whether it works forwards, not backwards.  The only analysis in the press release I could call prospective is the table at the bottom of page three.  It shows their vice composite with a marginally higher estimated growth rate than the Value Line universe (9.7% vs. 9.3%), and slightly more attractive valuation ratios.  Okay, that's a good point.  Vice stocks are expected to grow a bit faster and look to be a little cheaper.

Question 4:  Do the numbers look ok?
Answer:  No.
LK Comment:  The table at the top of page 2 presenting Domini Social Index vs. the S&P 500 appears to be in error.  It shows the Domini underperforming the S&P 500 for the 10 years ended September 30th, when KLD's 9/30 press release shows outperformance during that period.  They show the Domini Social Index for the 10 years at an annualized 8.74%, while KLD reports 9.97%.  I don't know, but I'll bet they used the Domini Social Equity Fund's performance instead of the underlying Domini Social Index, comparing a mutual fund with expenses to an index which has none.

  The QED press release claims the Domini Social Index is behind the S&P "for annualized periods of one, three, five, and ten years."  But comparing index-to-index using KLD's reported returns, it looks like Domini is ahead on its ten-year record, about tied on its five-year record, and behind over just the past one- and three-year periods.

Question 5:  Are returns risk-adjusted or presented in the context of a risk model?
Answer:  No.
LK Comment: Sometimes a study shows a significant performance difference between portfolios, but does not explain where the difference might come from.  In fact, there's a well-developed literature on determinants of differences in portfolio return.  The usual suspects are:

• Risk (beta)
• Size (market capitalization)
• Valuation (price/book ratio)
• Momentum (relative price strength)

Usually, these factors explain most of the differences in historical investment performance among portfolios.  If you use the variables listed above you're using a Carhart model, if you drop momentum you're using a Fama & French model.  The authors of this press release appear to have used neither.

And that's a problem.  Their argument is:  the Domini Social Index left returns on the table - given the data problems it is clearly not true for all the time periods they list, but it certainly has been true over the past one and three years.  The authors would like to show that this shortfall was because of the failure to own vice stocks.

But maybe it was just a failure to own value stocks or small stocks, both of which have had great performance lately.   The authors include some commentary on this, but without a risk model we can't know the answer with any precision.  And it's really important to know that answer:  if the Domini Social Index is underperforming because it doesn't own value stocks, that's a solvable problem (investors can supplement it with a value fund, or pursue other diversification strategies).  But if there's something really special about vice stocks, that makes it impossible to create diversified portfolios without them - well, that would be big news, and a big problem for social investors.

So those would be my questions, and after looking at the press release they haven't persuaded me.  To show that social investors are making a BIG MISTAKE by not owning vice stocks, they need to show that that excluding them creates unavoidable diversification costs.  And I'm not seeing it here.  From that perspective I'm a lot more concerned about Energy than the sectors they presented in this study.

Let me finish with a positive comment.  In addition to their retrospective analysis, the authors do some APT analysis of the excluded sectors (there is a good explanation of APT here).  This is new and useful work and deserves attention - I have not seen APT analysis of specific excluded sectors before.  Dan Dibartolomeo and I did an overall APT analysis of the Domini Social Index ten years ago (we used a different model than the one used here) and found that its macroeconomic bets differed significantly from the S&P 500 (see Kurtz,  Lloyd and Dan DiBartolomeo, "Socially Screened Portfolios: An Attribution  Analysis of Relative Performance." Journal of Investing, Fall 1996).  Dan updated this work in 1999 and that paper ("Managing Risk Exposures of Socially Screened Accounts") is available on the Northfield website.  Our analysis suggested the Domini index was particularly oil price-sensitive, and could underperform during a period of rising oil prices.  And we have certainly seen that.

Hopefully QED will follow this up with a more detailed white paper, or better, a journal article.  I think the APT aspect of this work could be a journal article in itself, particularly if the authors computed the APT coefficients for the Vice Composite they present on page three.

Article on Social Responsibility

I had several calls yesterday on Steven Pearlstein's Washington Post piece on social responsibility. I think the article is a solid and accurate one, written by someone who has obviously done some homework. (I should note here that Pearlstein praises Haas professor David Vogel's new book).

That said, I think Pearlstein misses some important aspects of the question. Much of the article frames the question as an ideological one. A picture of Ben Cohen, a mention of Milton Friedman - that's fine, and certainly shows the philosophical side of the debate.

But the question of whether social responsibility has financial impacts is an empirically testable proposition. And it has been tested. The most comprehensive work so far is Marc Orlitzky's meta-analysis (full study is here). Orlitzky finds a statistically significant positive effect, although it is much stronger at the firm level than at the stock market level. His analysis is the largest and most statistically sophisticated attack on the question to date, and one of only a very few directly addressing questions of publication effects and causality (does social responsibility drive business performance, or is it the other way around?) . Other recent studies like Tsoutsoura's find positive associations as well.

There are virtually no studies showing that social responsibility hurts companies financially. Economist Arthur Laffer recently released a study intended to take the other side. Although touted as a refutation, if you read the actual study it finds "there is no correlation between how well a firm performs its traditional business roles and where it is ranked in the Business Ethics survey." That is to say, they couldn't find a cost either.

But Laffer makes one point I strongly agree with. "Future efforts to evaluate the effect of CSR initiatives on profitability," he argues, "should be careful to tease out the specific financial impact of CSR initiatives..." In other word, let's narrow the focus and get specific about issues. Orlitzky argues, and successfully shows, in my opinion, that the concept of social responsibility can be expressed statistically. But it is still a very broad definition. Like Laffer, I would much rather zoom in on specific variables.

Doing so will not bring much comfort to critics of corporate social responsibility, however. Mr Pearlstein, here are some people you should consider calling:

• Nadja Guenster at Erasmus University in the Netherlands finds a positive association between environmental performance and operating performance over a long time period (see post below).
• Marc Orlitzky, who is linked above.
• You could call Charles Lee and David Ng at Cornell University. They find that global securities markets take corruption levels into account when valuing stocks.
• Paul Gompers at the Harvard Business School has shown that good corporate governance was associated with superior investment performance over time.
• Or Stuart Hart, whose work has shown that environmental policies matter for stock market valuations, and whose recent book is a careful and thoughtful analysis of the issue.

I would like to show you counterexamples: carefully-done studies that call these findings into question. But I have looked, and I cannot find them. Corporate social responsibility is not gaining momentum because of some ideological debate. It is gaining momentum because there is considerable empirical evidence that it matters.

I should also note that none of this suggests social investors have a performance advantage over other investors. Social investment studies show competitive performance, not outperformance over time (although the folks at KLD might disagree). If anything, the studies cited above suggest that markets are already aware of at least some of these issues, which would make it tough for a social approach to add performance on its own.

2005 Moskowitz Prize Winner

I had the pleasure last night of presenting the 2005 Moskowitz Prize to Nadja Guenster of Erasmus University in the Netherlands, who accepted on behalf of her three co-authors. (Official announcement is here.)

Nadja gave a great presentation on the study this morning at the SRI in the Rockies conference in Snowbird, Utah. Here is my abstract of the study, and the full text is available here.

If you are interested in the financial impact of environmental and sustainability practices, I think it is fair to say that this is a must-read. We have seen several studies showing environmental alpha in recent years, most recently Derwall(2005). But until now no one had really explained how or why this was happening. Nadja's piece is careful, thorough, and full of good judgments about methodology and data.

Congratulations also to Meir Statman, who received an Honorable Mention for his article on socially responsible indexes.  Meir is having a good year, as he also is headlining the just-released Journal of Investing special issue with a different piece on SRI.

Journal of Investing Special Issue

The latest The Journal of Investing is a special issue dedicated entirely to socially responsible investing.  If you have an interest in SRI, this is closest you are going to get to a full academic treatise on the topic.

I had seen some of the articles before they went in, and they looked very strong.  I'm very happy to see an article on Islamic indexes, an area that has received hardly any attention.

A full table of contents is here.