GLOBAL - Investors can achieve outperformance with socially responsible investment (SRI) indices if they use efficient weights, says financial research centre EDHEC-Risk Institute, despite its earlier studies suggesting SRI funds produced little alpha.

Speaking at the recent ‘Towards efficient and socially responsible indices’ presentation in London, Eric Shirbini, business development director at EDHEC-Risk Indices and Benchmarks, said: “You can create SRI outperforming indices using efficient weights. The main issue, really, is the weights used in the index.”
In December 2008, the EDHEC-Risk Institute published a study covering a six-year period ending in December 2007 showing that SRI funds distributed in France using environmental, social and governance (ESG) criteria to select stocks did not produce statistically positive alpha.

An extension of the study published in 2010, which included the financial crisis of 2008 and 2009, confirmed the statistically insignificant alpha over the longer time period.

In addition, SRI funds suffered a considerable increase in extreme risk and did not provide protection from market downturn.

But Noël Amenc, director of the EDHEC-Risk Institute, said: “The underperformance does not come from the SRI allocation - it comes from bad portfolio construction.”

According to EDHEC-Risk Institute, it is important to recognise there are two separate steps in any SRI investment process: stock selection based on individual qualities of company according to ESG criteria, and stock weighting, with most SRI funds using either a cap-weighting scheme or an ESG score or a combination of the two.

But Shirbini said cap-weighting in a reduced universe made even less sense than in a broad market portfolio, compounding the inherent problem of concentration in cap-weighted indices.

He said the ESG score neglected basic risk management information in correlations and volatilities before adding that state-of-the-art portfolio construction techniques, such as efficient portfolios, could be used to control risks and create better-diversified portfolios.

“We know cap-weighted portfolios are inefficient due to their concentration and poor diversification,” he said.

“Therefore, SRI investment should be about generating alpha using security selection - such as the SRI screen used by French civil servants pension fund ERAFP - and risk management.”

The ERAFP developed the FTSE EDHEC Risk Efficient Eurobloc ERAFP SRI index, which can be replicated passively, in 2011.

The pension fund runs a 100% SRI strategy.

Last June, Olivier Bonnet, head of SRI at the ERAFP, told IPE: “With a specific SRI index based on Vigeo’s data, we have control over the implementation of our criteria because the investment universe has been screened for compliance with our SRI framework.

“A customised index reflects our own individual SRI approach, which may differ from that of other investors, and which is why we have not chosen a sustainable index from the market.”