Does KLD's New SRI Dividend Fund Make the Cut?

I am a big fan of socially responsible investing [SRI]. I think investors can and should consider the social and environmental impact of their investments. Moreover, I am convinced that if SRI investing is implemented through the use of long-term index-based strategies, there is little if any penalty for doing so.

As a result, I was excited when Tom Kuh at KLD Research & Analytics told me that his company was preparing a SRI dividend index. I would love for investors to be able to replicate any investment strategy with an SRI approach, should they choose to do so, and equity income is certain a popular strategy right now.

Besides, I figured that the index would stand some conventional wisdom on its head. Think dividends and you think smokestacks, right? The folks who either distrust or dislike SRI (and they are legion) often trumpet the fact that SRI investments suffer from low yields. If KLD could come up with a dividend index that disproved that theory, it would be quite a coup.

The trouble is that the newly launched KLD Dividend Achievers Social Index (or DASI for short) comes up shy on a number of fronts. The index captures some of the weaknesses of traditional dividend indexes – like a huge weighting in Financial stocks – without the concomitant boost in yield. It feels like “dividend investing lite.”

The Methodology
The index has good bloodlines. KLD teamed up with dividend indexing giant Mergent to create the index, and the methodology was quite simple: KLD laid Mergent’s Dividend Achievers screen (which selects companies that have paid increasing dividends for the past ten years) and applied that to two large-cap SRI indexes: the Large Cap Social and Domini 400 Social indexes. Combined, the two screens coughed up 168 companies with a steady history of paying dividends. KLD put all the companies into the index at equal weights, and said it would reconstitute on a semi-annual basis, on February 1 and August 1.KLD says that the index shows “increased performance and lower volatility compared to an appropriate market benchmark such as the Russell 1000 Value Index.”

That’s kind of true. The index does perform well over the past five-year period, delivering 11.61 percent compounding annual returns versus 10.73 percent for the benchmark, with less volatility. But the KLD index has trailed the Russell 1000 Value over the more recent one-year and three-year periods, and lags by more than four percent year-to-date, as the chart below shows.

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That’s a mark of backtesting integrity for KLD, as it shows that they didn’t gussy up the index to create strong rear-view-mirror results. But it is also a significant lag, and could worry some investors.

Moreover, even over the favorable five-year term, the KLD index lags most traditional dividend indexes. For instance, the Dow Jones Select Dividend Index posted 12.96 percent compound annual returns over same time frame, beating the KLD index by 1.35 percent per year.

More worrisome to me are the underlying statistics of the index. We mostly associate dividend-paying companies with a value approach, but the DASI has a decided growth tilt. The figure below compares the KLD index to the Russell 1000 Value (IWD), Dow Jones Select Dividend Index (DVY) and WisdomTree (U.S.) Dividend Index (DTD).

Notice the yields: the KLD index trails even the straight Russell 1000 Value Index on a yield basis, and lags the WisdomTree and Dow Jones dividend yield by 27 percent and 49 percent, respectively.

Despite that, the KLD index comes with some of the traditional shortcomings of dividend indexes, including sector concentration: 43 percent of the index is made up of Financial names.

Some would argue that the problem here really lies, not with KLD, but with the idea of focused dividend indexes in the first place. Indexes like the Dow Jones Select Dividend Index represent a narrow, retail-oriented strategy that wouldn’t fit into most institutional asset allocation strategies. The WisdomTree Index comes closer by holding a more diversified portfolio of companies, but even its screens are highly debated within the industry.

But by launching a focused dividend index with just 168 names, KLD decided to play that game, and to play by its rules. And its rules, it seems to me, are simple: it’s all about the yield. On that level, the KLD index simply doesn’t measure up. With its lower yield and higher growth tilt, the KLD DASI index really does feel like “dividend indexing lite.”

The original premise of the SRI industry was that you didn’t have to compromise your investment principles (or results) to account for your social beliefs. I still think that’s true. I’d love to see more socially responsible international indexes and funds, and even sector products. In fact, if KLD wanted to go this route, it could have taken a couple of interesting approaches: it could have split the Domini 400 into growth and value components, or even partnered with a group like RAFI to launch a “fundamentally weighted” SRI index.

Going the dividend route, however, seems off. If investors want to put a dividend screen on their social investments, I suppose this is the best bet. But maybe that isn’t such a good idea in the first place.