Choosing a benchmark can be a tricky art, particularly if your portfolio is run according to ethical principles. Several index providers, including giants FTSE and Dow Jones, market socially-responsible investment indices, but are they suitable as benchmarks?
Pension funds running SRI portfolios face a choice. Either they take a specialist SRI index as the benchmark against which performance should be judged, or they go head to head with a broad market index, using an SRI screen to keep investments in line with the mandate.
“Clearly all pension funds need to measure the performance of their themed portfolios, such as SRI,” says Will Oulton, deputy chief executive at FTSE Group. “To do that, particularly for an SRI-themed portfolio, most standard benchmarks are not appropriate because they don’t take into account what the mandate is trying to achieve.”
If a fund pursuing an SRI mandate were to benchmark against a standard index, the result would be a significant performance differential, says Oulton. “That difference could be small or it could be relatively large if there’s a more specific mandate,” he says. “It would depend on the objectives of that mandate.”
However, some investment consultants see a danger in benchmarking against an SRI index. They believe that the performance of an SRI portfolio should be judged against the broad market. If it is not capable of achieving the level of returns won by the market as a whole, then the validity of the investment method should be questioned.
Pension fund trustees, after all, have a primary duty to get the best returns for their scheme members.
“We’re quite cautious about adopting a constrained index, because these indices are subsets of the broader market,” says Noel Grant of consultants Watson Wyatt. “If SRI is a style, it has to stand up and say it can beat the broad market.”
Many in the financial community insist that SRI must prove itself as a viable investment method, which is capable of delivering solid returns. It should not be a purely political choice, they argue.
Watson Wyatt believes SRI has a future as an investment style. As such, investors may choose to use it if it becomes accepted as common practice, to diversify. “It’s a way of making money… but you wouldn’t put your whole portfolio into it,” says Grant.
But currently, managers are struggling to make proof statements about SRI, he says. “There isn’t anything like the wealth of evidence out there as there is for growth or value strategies.”
However, he believes specialist SRI indices can be valuable tools. Ethical indices have attractions as comparitors, he says. But it is important to take into account the precise criteria an individual index is using.
“I would also want to see what is going on with SRI indices. One person’s view of what is the sensible way to create an SRI index is not another’s,” he says.
This is one of the core problems of ethical investment. Far from resting on concrete principles, the whole issue is debatable. There are no hard-and-fast ethical guidelines to which all investors adhere. While some see environmental considerations as the most important, for instance, others tend to emphasis human rights.
FTSE has addressed this issue by having an independent advisory group behind the index, providing the creators with a sense of what is currently being seen as acceptable corporate behaviour. If an index were not run independently in an open and transparent manner, then it would be possible that investors using it could end up with elements of bias, he says.
But in making an SRI index, the standards which its creators set might still not be acceptable to all investors. Oulton acknowledges that within SRI there are many different needs to meet. But the FTSE4Good indices are flexible enough to do this, he says.
“The choice is whether to use the SRI index as it is, in its entirety, as a plain vanilla product, or whether to add some criteria onto that,” he says.
“Any index can be customised and that is a fairly easy process,” he says. FTSE has a service which tailors indices to customers called ‘Customer Solutions’.
Dow Jones also knows that a standardised SRI index would not suit everyone. “We will probably not be able to provide a universe that fits every need in that market,” says Alexander Barkawi, managing director of Dow Jones Sustainability Group Indexes. The sustainability indices, too, can be flexible. The DJSI World index can be used with certain exclusions, such as alcohol armament or tobacco producers.
“With that flexible approach we cover pretty much everyone’s needs,” says Barkawi.
Customisation takes an extra effort which Dow Jones is willing to make, he says. The database which the index family derives from holds up to 50 criteria for sustainability, and these can be individually weighted to make a tailored index for a particular client.
“If you are integrating sustainability criteria, you may want to see a benchmark which is doing the same thing rather than a standard index,” says Barkawi. However, most pension funds using an SRI index as a benchmark would also keep an eye on a broad index, he adds.
But rather than using them as a benchmark to judge an active portfolio against, one of the best uses for SRI indices is for passive portfolios. “It’s a very efficient and effective way of putting sustainability in your portfolio,” says Barkawi.
The Swiss social security fund has an SRI mandate of Sfr500m (e342m) run against the Dow Jones Sustainability Index, he says.
Another advantage of using an SRI index as a benchmark – rather than simply taking a standard benchmark and using a screening process for the portfolio, say index providers, is their perceived reliability.
Index providers such as Dow Jones or FTSE have far more credibility than the majority of ethical investment consultancies, they say.
FTSE’s Oulton says a successful SRI index needs to be transparent, rules-driven and it must have its SRI criteria clearly stated. Independent governance and low turnover are also vital, he says. The FTSE4Good, he says is increasingly used by a number of clients as a benchmark.
“It depends on the objective of the portfolio,” he says. “An SRI benchmark is going to be closer to the performance of the portfolio than a standard benchmark would be.”
Rushdi Siddiqui is director of the Dow Jones Islamic Index. Islamic indices have a particularly important part to play within ethical investment, because they exist within an investment field that has broadly accepted boundaries.
“The Dow Jones Islamic Index has been in the public domain for nearly four years and in that time we have established a track record,” he says.
Even within Islamic investing, there is a divergence of opinion as to how to implement the principles. The Gulf standards of Islamic investment differ from the Malaysian standards, says Siddiqui. The Malaysian standards are slightly more liberal than the Gulf standards, he says.
Dow Jones selects its stocks for the Islamic Indices with the help of a Shari’ah Board of Islamic scholars. Four out of the five members of the board are from the Gulf, and the fifth is from the US. Siddiqui says the vast majority of money invested according to Islamic principles adheres to the Gulf standards rather than the Malaysian standards.