The following are in response to Adam Kanzer’s article, Exposing False Claims about Socially Responsible Investing, which appeared last week. Kanzer’s article was in response to Adam Apt’s article, Measuring the Cost of Socially Responsible Investing, which appeared the week before.
Major save! The Adler and Kritzman article was so bad that I was planning on cancelling my subscription to your service. (I just signed up last week.) If that article was any indication of reporting on your site, your site must be junk. But printing Kanzer's simple, clear, detailed response saved you for today. Keep journalistic standards, and forget the political bent.
Wells Fargo Advisors, LLC
I would like to respond to Adam Kanzer’s June 4, 2013 critique of my article with Timothy Adler, “Measuring the Cost of Socially Responsible Investing.”
Kanzer, like many others, confuses active management with socially responsible investing. If you select a set of companies with a particular socially desirable attribute because you expect them to outperform those that do not have that attribute, you are engaged in active management. If you select a set of companies with a particular socially desirable attribute regardless of how you expect them to perform, you are engaged in socially responsible investing. Consider the following thought experiment. You claim to invest in good companies to do good and because you expect good companies to outperform bad companies. However, you find at least one good company that you expect to underperform its bad company substitute, even though, on average, you expect good companies to outperform bad ones. If you choose the good company that you expect to underperform, you are socially responsible, but you incur a cost. If you choose the bad company that you expect to outperform, you are engaged in active management. You can’t have it both ways. The outperformance of the total portfolio comes from active management. The fact that you perform less well than you otherwise would if you select the one underperforming good company is a cost attributed to socially responsible investing.
It is trivial to deduce from first principles that skillful investors face an expected cost if their opportunity set is constrained. Consider, for example, an investor who is so exceptionally skillful that she is almost certain to identify in advance the best performing company from a universe of 1,000 companies. What is the likelihood that that company will be available to her for investment if her universe is reduced from 1,000 companies to two companies? Granted, this is an extreme example, but the principle applies universally. Constraints are costly, which is not to say they are bad.
My coauthor and I proposed a simple, unbiased framework that enables stakeholders to estimate the cost of restricting investment as a function of several relevant variables. Anyone who is interested can substitute their own assumptions of these variables into our framework to estimate the cost of restricting investment under different scenarios.
We did not argue for or against restriction. It may well be that the symbolism of divestment justifies its cost, but it is impossible to assess this tradeoff without knowing the cost. In my view, analyses that obscure a logically obvious truth, whether or not the obfuscation is intended, do not advance our efforts to combat climate change. Rather, such studies are unnecessary and harmful distractions that undermine those who pursue effective investment policies to expedite the transition from fossil fuels to renewable alternatives.
Adam M. Kanzer, in his response to Mark Kritzman and Timothy Adler’s paper on the cost of socially responsible investing (SRI), seems to misunderstand their argument. This may be partly my fault for not making clearer some of their main points in my own article about Kritzman’s talk on the subject. For my article on Kritzman’s talk, I saw my role as that of reporter, not commentator, so I left out my own views. I’d like to show where I think Kanzer goes wrong and then explain why I think Kritzman and Adler’s argument, while correct, is less important than they and Kanzer think it is.
Kanzer writes that “one of [Kritzman’s] core misconceptions [is that] there is no distinction [between active investing and SRI]. All forms of social investment are forms of active management, because SRI involves a process of principled decision-making.” But Kritzman relies on the definition of SRI given by Langbein and Posner, which makes just such a distinction. That SRI entails decision-making is not the critical characteristic. What matters is whether investors choose stocks that are expected to perform better than average or choose stocks for other reasons. If, as Kritzman said, you believe that socially responsible companies will be rewarded with superior returns and irresponsible companies will have inferior returns, and you invest accordingly, that counts merely as active investing. Active investing is choosing companies that, for whatever reasons, will have superior returns. SRI is different from active investing only when it motivates people not to invest in companies that they believe will have superior returns or to invest in companies that they believe will not have superior returns. This is Langbein and Posner’s definition.
If you believe that only socially responsible companies will have superior returns, then Langbein and Posner’s definition becomes irrelevant, and SRI and active management become the same thing, regardless of whether you actually achieve superior returns. As Kanzer correctly says, “Motivation does not correlate to financial results.” But Kritzman’s hypothetical costs become real if the manager’s beliefs tend to be correct.
Kanzer writes that “a rigorous study of the 18-year performance history of the MSCI KLD 400 Social Index, the longest-running index subject to multiple social and environmental screens, demonstrated that ‘the impact of the social screens appears negligible’ relative to the S&P 500. With respect to the index’s exclusion of the tobacco industry, ‘the cost of this policy rounds to zero.’” Kritzman stated explicitly, however, that his argument has no bearing on passive investing. His argument cannot address whether there is a cost to choosing the KLD 400 over the S&P 500. Kanzer’s argument here is beside the point. Kanzer also states, “Even passively managed SRI funds track indices that are themselves actively managed.” That’s not true. Yes, the KLD 400 index is managed, as are the S&P 500 and the Russell 3000, which Kanzer cites as a counter-example. There does not exist an index that isn’t managed. But that doesn’t mean that indices are actively managed portfolios.
Kanzer also argues that history proves that SRI does not lead to inferior returns. He takes Kritzman and Adler to task for not addressing the empirical evidence for SRI. But Kritzman states that history shows only what happened once; it cannot be extrapolated to the future.
While I agree with this, it seems to me that here we begin to see the weaknesses in Kritzman’s and Adler’s argument (at which I hinted in my article). When they run their simulations, they are calculating an expected cost (in the statistical sense). There is a distribution of values for this cost, and I believe that it is very wide. The costs could even be negative (that is, additions to value). Kritzman and Adler don’t tell us the distribution of their cost estimates. Kritzman might say that we have to make decisions based on expected values, because we have nothing else. My reply is that expected values are of most use when the distribution of values is very narrow, or when there are repeated trials. But 5, 10 and 20 years from now, there will only be one new history, and I am certain that the cost of active investing (if there is one) will be very different from the one that Kritzman and Adler estimate.
As more than one questioner pointed out on the evening of Kritzman’s talk in Boston, and as Kanzer, too, points out, Kritzman’s model is very crude. Kritzman replied that he had only offered a methodology, and that anyone was free to go and improve his model for Monte Carlo simulation and to come up with improved estimates.
Yet, in his op-ed piece in the Chronicle of Higher Education, Kritzman treats his estimates not as hypotheticals drawn from broad distributions of possible outcomes, but as actual, usable estimates of the costs of active investing. This places far more weight on his results than his methodology can bear.
My final complaint about Kritzman’s and Adler’s argument is that it presumes that portfolio managers have skill in security selection. That’s a strong presumption that even Kritzman doesn’t believe.1 (I personally believe that skill in active management exists, but that it’s extremely rare, so that most managers who think they have it actually do not.) For his and Adler’s argument to apply, it doesn’t matter whether the active managers believe they have skill (or even whether they believe that SRI will produce superior risk-adjusted returns). What matters is whether they really do have skill. If they don’t, then there’s no cost to SRI, other than the usual wasted costs of active management. For any actual portfolio to incur even an expected cost from choosing SRI, the managers must be skillful. (The transactions costs of divestment are beyond the scope of Kritzman’s and Adler’s argument.)
I am not a blustering anti-intellectual who dismisses theoretical arguments out of hand. In this case, however, while Kritzman and Adler are right in theory, they are very far from having proven that their conclusion has much bearing on whether to pursue SRI.
Consequently, I agree with Kanzer’s remark: “The study fails to ask the key question: How does the use of social and environmental factors to select investments affect performance?” The significant investment issues in SRI are the risk characteristics of SRI portfolios, which Lloyd Kurtz and others have explored, more than their expected returns.
I read with interest Adam Kanzer’s June 4, 2013, critique of Mark Kritzman and Timothy Adler’s “Measuring The Cost of Socially Responsible Investing.” Kanzer either does not understand basic portfolio theory, or he lets his desire to market a product color his judgment.
If you take a portfolio of stocks that are not perfectly correlated with one another, all of which have the same expected return, and divide it into two subportfolios, each subportfolio will have more risk than the original portfolio. As a result, the subportfolios, having the same expected return as the original portfolio, will have lower Sharpe ratios than the original. This result is a mathematical certainty and is not dependent on circumstances.
But Kanzer counters that in this case the two portfolios – socially responsible stocks and other stocks – do not have identical expected returns. Of course he thinks the socially responsible portfolio has better returns – that’s why he’s built a portfolio of them and is marketing it. But he could be right or wrong. Anyone can make that claim about any strategy.
In Kanzer’s case, he has identified a factor, no different in principle from value, small capitalization, momentum, low volatility or any other factor that is used to screen stocks, that he believes will beat the market and generate alpha when the return has been properly risk-adjusted. We won’t be able to evaluate his claim until the portfolio has been held for a good while. The claim that one portfolio is better than another (in technical terms, that it has a higher expected Sharpe ratio than the other) is just a claim that the person constructing that portfolio can add alpha.
Ex ante, we know that about half of all active managers will add alpha before fees and other costs. Ex post, we’ll know which ones did. That is all you can know about the future performance of any active strategy, no matter how well it performed in the past. Any claim beyond the ordinary one (“I have a way of beating the market that makes logical sense to me but we won’t know until we try it”) should be disregarded.
Meanwhile, Kritzman and Adler’s thought experiment, which shows how much you lose by sacrificing diversification, is correctly conceived and executed.
Laurence B. Siegel
Gary P. Brinson Director of Research, Research Foundation of CFA Institute and Senior Advisor, Ounavarra Capital LLC
The following is in response to Dan Richards’ article, How a Golf Outing Led to a $2 Million Client, which appeared last week:
Dan Richards’ piece on quality client acquisition was spot on and nearly took my breath away. Why? Because I read it shortly after coming off a keynote stage where I had just interviewed an advisor, practicing in rural Florida, who has added $50 million in each of the last 5 years. This advisor’s motif for marketing is strikingly similar to that of the billion-dollar advisor in Richards’ article.
In today’s world, building an extraordinary practice starts with the passion of the advisor. The sooner the advisor gets clarity on that, the better, because clarity is power. The advisor I reference — let’s call him Tom — is an avid and competitive polo player. Five years ago, Tom decided to abandon conventional approaches to growing his independent business – no more cold-calling, letter writing, rubber chicken seminars or asking for referrals. The impetus for this transformation was a quote by John Maynard Keynes: “It is better for reputation to fail conventionally, than to succeed unconventionally.”
Tom snubbed his nose at the industry’s siren call to “always be closing.” (Think of the horrors of Alec Baldwin in the movie “Glengarry Glen Ross.”) Instead, he committed to taking “outrageously good care” of clients and prospects that fell into his world of polo playing. For example, Tom orchestrated champagne tastings under a magnificent tent after events and has worked on delivering memorable toasts honoring outstanding participants. It is a genuine, delightful experience for all involved. I would argue that Tom’s success couldn’t be replicated, because polo playing is his unique business niche. He loves and dominates the space.
Everyone has a space. It might not be fancy golf outings to Ireland or polo playing with Florida elite, but there’s some abiding passion of yours that would love to show its face and grow your business. Find it, and go to it boldly and unconventionally.
John L Evans Jr
The following is in response to Robert Huebscher’s article, Niall Ferguson: Four Reasons Why the U.S. is Failing, which appeared on May 7:
I am not as familiar with Ferguson’s work as it appears I ought to be, and your recap inspired me to remedy that. You mention Krugman as the antithesis of Ferguson. That struck me as a good example of the oddity of the term “science” in the phrase “social science.” In the full range of disciplines that fall in the categories of social sciences, there is plenty of divergence of opinion, theory and hypothesis for things that will or should happen. What causes me to think that economics in particular is still far from a science is that the same level of divergence also occurs for things that have already happened. Our understanding of facts can’t even be pinned down.
There are parallels in natural sciences, but predominant theories emerge in the natural sciences in most cases. We don’t normally have two major camps with opposed theories battling for multiple decades in natural science. Someone eventually creates an experiment that pulls one theory well ahead of the other, or a technological breakthrough in measurement devices solves a causality dilemma. In economics, the pro-Keynesian and anti-Keynesian debate has been unresolved for decades. The causes and outcomes of governmental recovery policies during the Great Depression and 2008 recession remain in hot dispute.
Robert P. Wilson
CFO & CCO
Wealthcare Capital Management, Inc.
Read more articles by Various