Socially Responsible Investing
A Response to Adler and Kritzman
June 4, 2013
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After nearly 30 years of growth and development, the field of socially responsible investing (SRI) is still poorly understood. Those of us who are practitioners in the field must, of course, shoulder some of the blame for this. But I attribute a significant amount of the misunderstanding to the transformative nature of social investing. It is difficult to fit an investment strategy that places an emphasis on social and environmental outcomes into traditional models. Although the field has become more mainstream in the past decade as large asset managers have discovered alpha in environmental, social and governance (ESG) factors, SRI still confounds and challenges.
When the Domini 400 Social Index (now known as the MSCI KLD 400 Social Index) was launched in 1990, the common wisdom said that if you limited your investable universe by anything other than financial factors, you would limit your returns. The performance of the index has proven that assumption to be false. Nevertheless, the assumption lives on.
Measuring the Cost of Socially Responsible Investing (Adam Jared Apt, Advisor Perspectives, May 21, 2013) is a case in point. The articlereviewed a 2008 paper written by Mark Kritzman and Timothy Adler that concluded, “socially responsible investing, properly understood, incurs a cost to the portfolio.”1 The core of the study rests on that phrase “properly understood.” In fact, after reading the study, it is clear that SRI is not well understood at all. The study is based on serious misconceptions about the process of social investing and its outcomes. In my view, the study has no application to SRI or the current debate over fossil-fuel divestment.
The Adler-Kritzman study used a Monte Carlo simulation to model and compare expected returns from a constrained and an unconstrained investable universe, at various levels of active-management skill. To create the constrained SRI universe, Adler and Kritzman “randomly deleted some fraction of the original universe to capture the effect of restricting a universe for purposes unrelated to expected performance. By randomly deleting observations, we assumed implicitly that good companies are no more or less likely to outperform bad companies.”2
If this assumption is false – or is only false for certain types of companies – the study falls apart. This assumption also ensures that there is no place in the study for any degree of skill in implementing social and environmental factors.
The study fails to ask the key question: How does the use of social and environmental factors to select investments affect performance? The study’s authors assume these factors have no financial relevance, apparently because certain investors that utilize them are not primarily motivated by financial considerations.
The study is therefore not designed to determine whether there is a cost to SRI. Rather, it is meant to illustrate a point the authors consider to be axiomatic. Kritzman introduced his paper to an audience at Middlebury College in January, as follows, “I know you all accept that there’s a cost [to fossil-fuel divestment], right? I’m going to tell you how you go about measuring it.”
1. Timothy Adler and Mark Kritzman, “The Cost of Socially Responsible Investing,” Journal of Portfolio Management, Fall 2008, vol. 35, no. 1, pp. 52-56.
2. Curiously, later in the study, the authors asserted that they made no such assumption: “We make no assumption about the relative performance of ‘good’ companies and ‘bad’ companies.” They did, however, by assuming these characteristics are unrelated to performance.
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