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Indices in search of a role

In the past three years, there has been substantial growth in interest in socially responsible investment(SRI) indices in both the UK and Europe. SRI indices are intended to track the performance of a set of companies chosen according to certain environmental and social criteria as being more socially responsible. They are thus sub-indices of their underlying markets, with a ‘green’ tinge.
SRI indices have been around for some time, particularly in the US, where the Domini 400 index is well established and over 10 years old. In Europe, the principle indices are the Dow Jones Sustainability Index (DJSI) and the FTSE4Good indices. The DJSI includes the top 10% of companies in the main Dow Jones indices, based on an evaluation of a triple bottom line of social, environmental and economic performance. In contrast the FTSE4Good indices, based on the FTSE series of indices include a rather larger proportion of the market (around 50%). The evaluation methodology is less complex but more transparent.
Both indices have attracted substantial press comment and some market interest. In particular, a number of funds based on the DJSI have been launched on the continent – some 37 funds and e2.2bn of assets. The FTSE4Good has found it harder to develop business, with one fund.
For many investors the key question is how the indices perform. Here the evidence is good enough to encourage those who believe that SRI are capable of long-term outperformance, but not enough to convince those who are more sceptical. The Domini 400 has a very good long-term track record, although it had a very poor 2000 and a weak 2001. The DJSI indices got off to a poor start but have since more than recovered. (Note that results from back-testing of these indices is of questionable value.) At the very least the experience with the indices shows they have similar performance (and absolute risks) to mainstream benchmarks. They thus reassure more nervous investors that a decision to go for SRI is not a very high risk or dangerous one. Note too, that most of the indices take a pre-defined approach to SRI and have not sought to optimise their selection criteria to enhance performance.
In terms of investment theory, SRI index funds occupy somewhat unusual ground. Unlike conventional benchmark index funds, which appeal to those who accept that markets are efficient and that is it very difficult to beat the market, SRI indices represents something of a hybrid – essentially, portfolios based on them are not taking a view on traditional financial criteria (ie passive in conventional terms) but are taking a view on social responsible criteria (so ‘active’ on social and environmental aspects). Of course, it is reasonable to argue that while conventional financial information may be efficiently factored into prices, the market is less perfect in environmental and social information, leading to market opportunities. Nonetheless, this hybrid nature does limit their appeal.
Again, in cost terms, SRI indices represent something of a hybrid: more expensive than the very low costs associated with the large indexed funds, but generally cheaper than active fund management, and SRI fund management in particular.
One issue for SRI indices is that they can involve significant risks relative to the underlying market. Much of this risk comes from style or sector biases. For example, the DJSI contains country bias, the Domini 400 contains a growth bias and the FTSE4Good sector biases. These biases often lie behind much outperformance and underperfromance. While the extent of these biases is not huge, and SRI indices still include a wide spread of investments, investors need to be aware of these risk factors and ensure they are happy with the exposure.
SRI index funds may be worth considering for the following types of investor:
q Those who believe that it is very difficult for active fund managers to outperform using traditional financial criteria but that it may be possible for non-financial criteria to add value. Such investors are likely to be relatively few – for most, views on the efficiency of markets will predominate over views on the impact of social responsibility on performance.
q Those who believe in efficient markets and prefer indexed investments, but are interested in the idea of SRI and find the cost and (relative) risk implications acceptable (note that such investors, believing in efficient markets, will assume that the expected return is the same as for non-index funds).
q Investors who wish to explore the concept of SRI, or to test the potential of SRI in a relatively pure way without the involvement of an active fund manager, or who are not particular satisfied with the active SRI managers they have seen.
One of the unsatisfactory features of SRI indices is that they essentially classify companies as good or bad – in the index or not. In real life, most companies have some positive features and some negative ones; simply classifying them as either in or out of the index is a gross simplification. SRI indices need a one-size-fits-all approach to corporate social responsibility, whereas what is actually important will depend on the particular circumstance of the company. Indeed it is often in the complexities of where a company is good and where bad that much analytical insight can be gained. This simplification means indices miss out on many of the interesting (both in financial and corporate responsibility terms) aspects of SRI.
One of the criticism of SRI indices originally was that the index compilers did not adequately engage with companies and it was relatively difficult to find out what was necessary to gain inclusion. However, since then index compilers have aimed to make their processes more transparent, and it has become apparent that the impact of SRI indices on company behaviour is a major benefit of SRI indices – many companies are very keen to be included in the indices and have sought to identify what needs to be done. The public nature of SRI indices has been a key feature in this. However, the engagement with companies created by indices is somewhat one-dimensional – companies are interested only in what will get them in the index, so such engagement does not help either the no-hopers or the companies already in the index. Furthermore, engagement around SRI indices cannot focus on specific issues or emerging topics.
In its white paper on corporate social responsibility, the European Commission appears very positive towards the concept of SRI indices – stating: “European market indices identifying companies with the strongest social and environmental criteria will become increasingly necessary for those as a basis for launching SRI funds and as a performance benchmark for SRI.” This has aroused considerable controversy, and appears to be based on misleading ideas about the role of SRI indices. No funds (except the relevant indexed funds) have found it necessary to have SRI indices as a basis for launching funds. The idea of SRI funds as a benchmark has also come in for criticism. For example, the UK Social Investment Forum, in its response to the white paper, stated: “There is no evidence that retail SRI funds wish to use a customised SRI benchmark rather than using standard market benchmarks. Nor is there any demand from institutional SRI investors for special SRI indexes to be produced. We believe that the requirements of both individual investors and the fiduciary responsibilities of institutional investors will continue to encourage fund managers to use standard benchmarks.”
The greatest concern has been that the EC seems to regard SRI index funds as the best way forward for SRI. This may be a little unfair, but the SRI market is very concerned about having a particular approach imposed on it, and the sounding of the commission has resulted in a strong response. Part of the problem is probably a lack of financial understanding on the part of the commission about the role of SRI indices. In view of the clear feedback it has received, it should now have a better understanding of how they fit in.
SRI indices will have a number of uses, but perhaps less in scope that their developers envisage. They are unlikely to be used as benchmarks by most SRI fund managers, but they may find a role in doing attribution studies of fund managers’ performance – helping to indicate what part of over- or underperformance may be due to SRI factors (although many fund managers argue their approach is so different from that of the indices such analysis is of limited use). SRI index funds will appeal to some investors, particularly ‘light green’ investors who like the idea of a reasonably balanced, low-risk SRI option. Finally, they will help raise the profile of SRI, and encourage debate on this interesting and topical area.
Mark Mansley is with Claros Consulting, a specialist adviser on SRI investment strategies and research for fund managers and institutional investors. E-mail mark@claros.co.uk

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