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Index Universe assistant editor Heather Bell chatted with KLD's Peter Kinder and Thomas Kuh, Ph.D., shortly before the launch of KLD's latest index, about the firm's new global sustainability index, the evolution of socially responsible investing [SRI] and changing attitudes toward SRI.

Kinder is the president of Boston-based KLD Research & Analytics Inc. [KLD], which he co-founded in 1988. He was also one of the co-founders of Domini Social Investments LLC and was a principal there from 1997 to 2000.

Kuh is the managing director of KLD Indexes, a division of KLD Research & Analytics, Inc. He is also a member of KLD's Management Committee.

Index Universe: Tell us about the new global sustainability index, and what drove that development.

Kuh: We actually began work on a global index I think in 1999. As you might imagine, it got derailed by the market in 2001, and a couple of years ago we turned our attention back to the project.

Kinder: The big change is that the institutional investors who were nibbling around the edges of global investing now are firmly in global investing. I think it's hard to imagine institutions 10 years ago really looking at this field in the U.S. very seriously, but now they're very serious about it. The second thing driving this development is the interest of institutional investors in the environmental, social and governance criteria. Again, this is something that very few were even aware of 10 years ago, and now we have the Principles of Responsible Investment with $10 trillion under management by its signers. So these two factors have really driven us to produce a family of indexes that institutions can use in dealing with sustainable investing.

The timing is also in our favor here because the approach to screening has evolved significantly since we launched the Domini in 1990. There is much more concern about looking at sectors and the rankings of companies within sectors, and looking for opportunities affirmatively to buy if you will, looking for reasons to keep companies in. And this has dictated a different type of use of the environmental, social and governance factors today than we would have done in 1999.

Index Universe: How is the new index constructed?

Kuh: It will be a mother index, if you will, what we're calling the KLD Global Sustainability Index (KLD GSI). And there will be regional subindexes for North America, Europe and Asia-Pacific, and then various combinations and permutations. For example, we will have a global ex-US version, and we can create others as well.

We selected the S&P Citigroup BMI World as our data source for constructing the eligible universe for the KLD GSI. We constructed the eligible universe by taking 75% of the market cap in each sector in each country. And then what we did is we took the eligible universe for each of these three regions—North America, Europe and Asia-Pacific—and went through a ranking and selection process. First, we ranked the companies based on their environmental, social and governance scores within each sector, and then we selected 50% of the market cap in each sector in each region. The result is a set of three regional indexes that are sector-neutral, and a global index that's sector-neutral.

One ... of the things we've consistently heard over the years is that to the extent that SRI indexes have tracking error relative to an underlying market benchmark, it's always considered to be a bit of a problem. Obviously some tracking error can be tolerated, but what we decided to do ... is eliminate that part of the tracking error that's associated with sector variances. So it removes some of the systemic risk that a lot of SRI indexes have.

Index Universe: Are there any other ways this index is different from what you've done before?

Kuh: In the past we've used categorical exclusions for things like alcohol, tobacco, gambling, weapons and so on. And we took a somewhat different perspective in creating this index, which focuses less on ... the moral perspective on those activities as "sinful" activities and more on the impact of those goods and services on society, whether it's on their consumers or more broadly on public safety and public health. That's the sense in which we consider it to be a sustainability index rather than what I would call a more traditional SRI index.

The net impact of changing the way in which we do the screening is that it does allow us in some industries that were highly underrepresented in some of our other indexes to get better representation. An example is in utilities, where in the past we had an absolute prohibition on nuclear power. We treated nuclear power differently this time, looking instead not just at whether or not a company has an interest in a nuclear power plant but, in addition to that, what their overall fuel mix is and what role nuclear plays in that, whether or not they've had substantial safety issues related to nuclear power, and whether or not as an energy producer they've taken leadership in the development of alternative and renewable energies.

Index Universe: SRI indexes tend to be underweight in sectors like Basic Materials. Has that hurt the performance of your indexes with the recent run-up in Basic Materials?

Kuh: With these things, it always depends on what periods you're looking at, but actually in general, our indexes have been performing quite well lately. We expect our indexes to perform consistent with the market, and they generally have been. Certainly to the extent that we've been underexposed in areas like Basic Materials and in Energy, for example, while those sectors have been performing strongly, it has hurt performance.

Index Universe: I've noticed that attitudes toward issues like nuclear energy have definitely been changing lately.

Kinder: One of the things that changes over time in investment is how companies are viewed, and that's not true simply of social investors, it's true of the market in general. Any time you're doing an index that's trying to gauge a market, one has to be critically aware of the changes over time in that market. And certainly amongst institutional investors there is a growing sophistication on many of these environmental and social issues. One would expect it in governance. But the change in attitude on issues such as global warming changes how an institutional investor is going to look at the utility sector generally ... and what we're trying to do with this index is capture that evolution.

Index Universe: How does KLD define socially responsible investing?

Kuh: The traditional definition of socially responsible investing is that it is the incorporation of social, ethical or religious criteria in the investment decision-making process. That's the traditional off-the-shelf definition. And it's a definition that, when the field was primarily retail, worked very well.

But institutional investors don't have the same kind of impulse toward alignment of ethics and investments that individual investors have. They are looking at these criteria as—to use a phrase I really don't like—value drivers. They are looking at them in terms of indicators of risk. They are in a sense—and only in a sense—looking at these in a context that is not value-laden the way that an individual investor would tend to. So if one is designing an institutional product in the sustainability or SRI space, it's going to look somewhat different from what one is going to design for an individual investor. What we've done is re-conceptualize these issues in the context of globalization.

Over the past close to 10 years we've been working with a number of research organizations based in different countries around the world, and have developed what we think of as a global perspective on these issues. I think up until very recently there were pretty distinct differences between how many of these issues were conceived of in the U.S., in Europe and in Japan. Many of those differences still exist, but at the same time, I think there's a lot of consensus about the relevance of environmental, social and governance issues and how they should be interpreted in the context of evaluating corporations.

Index Universe: How much of the evolution stems from investors becoming more educated on these issues?

Kinder: No question the degree of awareness of the global nature of these issues has increased. You can't even put a word to it— "exponentially" doesn't even capture it. The thing that's driving, for example, the Principles of Responsible Investment, is the awareness that global warming means global, that decisions in the United States about the fuel mix of our utilities have an effect around the world, that these are not independent decisions that end at the three-mile limit. What is fascinating to me is watching this awareness of global warming drive an awareness of interrelationships in other areas such as supply chain, human rights and the like. Once people become aware that these are global phenomena in one area, it drives an awareness in the other areas. So things are changing very rapidly intellectually in financial services.

Index Universe: Are there any trends or themes that are emerging in the SRI space?

Kuh: Responsible real estate—or "green" real estate—I think, is something you'll see more. Another trend we're seeing is a growing interest in SRI and sustainability fixed income indexes, because so far the focus has really been on the equity side of the market rather than the debt side of the market. But many of the same principles can be applied to fixed-income securities, particularly corporates and agency securities. These are things that we hear demand for.

I think, generally speaking, a lot of the thematic indexes you see these days coming out of more mainstream places reflect an interest in particular SRI issues. I think that a lot of thematic indexes really reflect the way in which the mainstream appropriates SRI issues, because a lot of the issues that we look at don't map directly to industry or sector categories that currently exist. And so they fall into the rubric of thematic.

Kinder: I would add to that. What you're seeing at the same time is an increasing sophistication amongst institutional investors—in many cases a sophistication that individual investors have brought to the table for a much longer period—but nonetheless they are looking at these ESG issues very seriously. At the same time, the market for retail products or for products that are targeted for the traditional SRI marketplace has become much broader. There's a very considerable move to fill most of the niches that exist for non-SRI investors in the SRI marketplace. You're seeing a significant increase in product and types of product and specialized products in the SRI space. I see nothing that indicates that is slowing down; if anything, it's increasing.

Index Universe: There are financial advisors and the like who will say SRI investing is not viable because you lose basis points on your returns. Do you have a response to that attitude or that outlook?

Kuh: This is the myth that won't die. I think that there's any number of academic studies on both active and passive portfolios showing that there is no necessary reason why using environmental, social and governance screens should harm performance. I think it's a kind of a knee-jerk response and an easy answer to a complicated question. I think the argument that of course it's going to hurt your performance rolls off the tongue somehow in spite of the fact that there doesn't seem to be much evidence that it's the case. Anybody can certainly take selective periods and say you know, this index has underperformed in this period, or that index has underperformed in that period, but over the long term and based on a broad range of academic studies, it just doesn't stand up.

Kinder: You'll see in academic articles—and I just finished reading one today—where they'll say things like, well, a lot of portfolio theory dictates that if you limit your universe you'll limit your performance, and you necessarily have to give up something if you limit your universe. And that's what we call in politics a head nodder. Nobody really thinks about it. It's an article of faith that people simply don't examine, and that's one of the real problems we have in SRIs. People don't really look at these assertions very carefully.

Kuh: I would say that the trend these days that Peter referred to earlier based on the interest of institutional investors is in fact just the opposite. It's really an interest in understanding how it is that environmental, social and governance factors can be understood as helping to uncover both risks and opportunities in companies and ways of avoiding the downside of the risk and capitalizing on the opportunities. Again, I think the situation is one in which the questions that are being asked are much more sophisticated today than the questions that were being asked 10, 15 and 20 years ago. And it's not that we have all the answers, but I think there's a broad recognition—increasingly so in the mainstream and not just among social investors—that these are issues that affect the performance of stocks and should be taken into account in every investment decision.

Index Universe: Did your screening and evaluation processwhich covers business practices, among other issueshelp to lessen the impact of the subprime mortgage market meltdown on your indexes?

Kuh: Absolutely. We've been tracking this issue under a screen we call predatory lending for 18 years, and as a result, certainly avoided most of the worst culprits in this. Obviously, to the extent that securitization has sort of spread the benefits, if you will, of subprime lending broadly across the marketplace, it's impossible to avoid altogether any connection with subprime mortgages. But it is an issue we have followed very carefully, not simply because we were concerned about the possibility of the market blowing up, but because we were concerned about the social impact of subprime lending badly practiced and because it can have devastating effects not only on individuals and families but on whole communities. For that reason it's been something we've looked at carefully over a long period.

Kinder: There are people who do subprime lending right. There's a whole category of financial institutions that does subprime lending, and here I'm thinking about South Shore Bank (now ShoreBank Corp.), University Bank in Minnesota. These people do subprime lending; that is their business.

Kuh: Also, Self-Help Credit Union in Durham, North Carolina.

Kinder: And they do it right. They provide assistance to the borrowers; they keep the loans on their own books; they don't securitize them. It is done to build community. So it's something that social investing can really talk about, both from the side of having a bellwether for looking at who does it wrong and also for providing a means for doing it right.

• Read more on Socially Responsible ETFs

Source: KLD's Kinder and Kuh Discuss Socially Responsible Investing