The FTSE KLD 400 Social Index (KLD400) celebrates its 20th anniversary this month. The world’s first benchmark index constructed using environmental, social and governance (ESG) factors, the KLD400 sparked a new era of responsible investing, helping transform the field from a small niche into today’s $6.7 trillion global market. [Source: Eurosif 2007] Since 1990, the KLD400 has outperformed the S&P 500, proving that a portfolio constructed using ESG criteria can, over the long term, deliver competitive risk-adjusted returns.
Dan DiBartolomeo and Lloyd Kurtz, who was one of the original KLD employees apart from the firm's founders, have studied the risk and return characteristics of socially screened portfolios over the past two decades.
Dan and Lloyd spoke to us about the KLD400’s contribution to mainstream investing, how SRI has evolved over the past 20 years, and some of the challenges that remain. [Ed. Note – Biographical info for Dan and Lloyd can be found at the end of this interview.]
What were some of the challenges you faced when creating the KLD400?
Lloyd Kurtz: From the beginning, it was apparent that it was a different animal than the S&P 500. It had different sector bets and some kind of a growth bias, and it was unclear if the performance would be comparable to the S&P 500. But our initial analysis in the early 90’s of the risk bets of the KLD400 showed it was performing about the way you’d expect it to. And actually the social factor, which had been a topic of much speculation, wasn’t driving or harming returns.
How did that help garner support for socially screened portfolios?
Dan DiBartolomeo: The KLD400 proved that the loss of diversification in socially screened portfolios just isn’t big enough to be economically or statistically noticeable.
LK: And that was a big deal. Back in those days, there was a strong point of view that there must be a persistent cost to bringing social awareness to your investment approach. The initial construction of the KLD400 showed that its returns were explainable by conventional investment factors, which also meant they were manageable. That piece was critical to the growth of social investing. It meant you could take a quantitative tool and bring a socially responsible portfolio of stocks to the risk level you wanted, without having to worry about the impact of social screens on long term performance.
DD: For example, if you removed alcohol, tobacco and firearms from the S&P 500, you’d lose about 6% of market cap. If you then tried to manipulate the 94% that is left to make it look more like the original portfolio by patching the missing pieces in terms of dividend yields and sector weights, the difference in terms of risk isn’t noticeable because it’s too small to measure.
Is SRI an alpha factor?
LK: I would suspect that the alpha of the KLD400 has been statistically indistinguishable from zero, but that’s still important. It means SRI is a free good. You can construct a competitively performing portfolio that doesn’t include enterprises you object to. For religious and social investors, that’s a big deal. The index has demonstrated over its 20-year history that competitive returns are possible. And now there are a couple studies to suggest that there are certain social factors that when emphasized could yield positive returns.
What are some of those factors?
LK: A 2004 study by Bauer, Derwall, Guenster, and Koedijk called "Socially Responsible Investing: The Eco-Efficiency Premium Puzzle" showed that there was some benefit to incorporating the environmental policies of companies into alpha generation strategies. Another example is a 2009 paper by Wharton’s Alex Edmans on the relationship between employee satisfaction and long-run stock returns. It showed that the “100 Best Companies to Work For in America” have been consistent outperformers over time.
DD: We’ve also been working on a study of the idea that companies that pay attention to social factors will survive longer, and be more successful in the long run, than companies that don’t. We developed an analytical model based on a methodology from sociologist Robert Merton that tries to predict how long a company can sustain itself before going broke. The expected life measure is in favor of the KLD400 when compared to the S&P 500. The reasons for that are not completely attributable to social factors, but KLD400 firms tend to outlast those screened out of the index.
LK: That outcome highlights the fact that we live in a transactional economy; some companies are run to be sold. If you’re running a company to be sold, your time horizon is shortened and you stop focusing on things that appeal to social investors, like employee ownership, charitable giving programs, and high R&D. It makes sense that companies favored by social investors are companies that are expected to live longer, because they’re designed that way.
What is the KLD400’s biggest contribution to the investment world?
LK: Apart from being first, the index has shown that social investing isn’t just a side show. It can help answer questions about financial theory. Part of the power of the KLD400 is that it has been open to inspection; the performance has been reported vigorously from day one. That intellectual honesty that KLD has promulgated throughout this process is one of the reasons the KLD400 has been a successful benchmark and an important reference point for social investors.
What are some of the remaining challenges associated with SRI?
LK and DD: Social investing is moderately more difficult than regular investing because of the extra attention given to risk management. But one of the first steps to broadening the appeal of social investing is to build trust at the financial level. We’ve been able to show that we have our arms around the type of risk associated with this approach and can explain how to manage it, along with the possible benefits. And in the case of the KLD400, there is, since inception, a noticeable performance advantage.
Dan is President and founder of Northfield Information Services, a Boston-based firm that develops quantitative models of financial markets. Dan is also a Visiting Professor at the CARISMA research center of Brunel University in London, and serves on the Board of Directors of the Chicago Quantitative Alliance and the advisory board of the International Association of Financial Engineers. He also serves as a judge in the Moskowitz Prize competition, given for excellence in academic research on socially responsible investing.
In addition, Dan has written extensively for the CFA Research Foundation and a number of journals. His most recent publications are “Just Because We Can Doesn’t Mean We Should: Use of Daily Data in Performance Attribution” published in the Spring 2003 Journal of Performance Measurement, and the “DSI Catholic Values 400” (with Lloyd Kurtz in Journal of Investing 2005).
Lloyd is a senior portfolio manager at Nelson Capital and a lead PM for socially responsible investing. Before joining Nelson Capital in 2004, Lloyd was a Senior Vice President at Harris Bretall Sullivan & Smith in San Francisco where he served as Director of Quantitative Research and provided research coverage for the healthcare, basic industry and energy sectors. Prior to joining Harris Bretall in 1995, he spent four years as Senior Research Analyst at KLD, a Boston research firm specializing in social investment research. At KLD, he did much of the initial quantitative work in the development of what is now the KLD400 Social Index.
Lloyd is a Lecturer at the U.C. Berkeley Haas Business School's Center for Corporate Responsibility, a faculty advisor to the student-managed Haas Socially Responsible Investment Fund, and serves as Program Administrator for the Moskowitz Prize. He has published many articles on SRI in academic journals, and in 2008 authored a chapter on SRI for the Oxford Handbook of Corporate Social Responsibility.
He holds a B.A. from Vassar College, an M.B.A. from Babson College, and is a Chartered Financial analyst. In 1999, he received the SRI Service Award for his contributions to social investing.