Socially Responsible Investment - September 19, 2011

SRI funds do not perform particularly well in comparison with indices - an interview with NoŽl Amenc

In this month's interview, we talk to NoŽl Amenc, Professor of Finance at EDHEC Business School, Director of EDHEC-Risk Institute, and Chairman of EDHEC-Risk Indices & Benchmarks, about a new EDHEC-Risk Institute study, "Performance of Socially Responsible Investment Funds against an Efficient SRI Index: The Impact of Benchmark Choice when Evaluating Active Managers."

NoŽl Amenc

EDHEC-Risk Institute has just released a publication entitled ďPerformance of Socially Responsible Investment Funds against an Efficient SRI Index: The Impact of Benchmark Choice when Evaluating Active Managers.Ē Could you tell us about the general conclusions of this publication?

NoŽl Amenc: Well, one of the first conclusions is that SRI funds do not perform particularly well in comparison with indices. In our study, we provide the performance of SRI funds in relation to the index and we show that the vast majority of funds do not perform well. The results show that about 44% of SRI funds exhibit a positive alpha with regards to a non-SRI cap-weighted benchmark, while only 10% of SRI funds obtain the same result with a non-SRI efficient benchmark. If we use SRI benchmarks, this proportion declines from 40% to 19.5%.

The reason is that the SRI approach is a stock-picking one which cannot replace an efficient portfolio diversification approach. In that sense, building a portfolio by only using SRI scores means missing out on the more than 50 years of research into modern portfolio theory on which diversification is based. Moreover, seeking to use an SRI score as a weighting method, even though SRI is not a specific risk factor and there is no research showing that a factor of that kind would be rewarded, does not make much sense from either a theoretical or practical point of view.

Does that mean that one shouldnít invest in SRI?

NoŽl Amenc: Not at all. The SRI approach can absolutely be justified, either through a microeconomic approach by choosing securities that have interesting extra-financial qualities that will be recognised by the market over the long term, thereby avoiding large losses, or for more macroeconomic reasons by participating through oneís investment in a socially favourable approach such as environmental protection, or human rights, etc.

In any event, this approach, which is based on security selection, and therefore a reduction in the universe, still requires a portfolio construction process that takes the securitiesí financial risk parameters into account, notably their volatility and correlation. If these aspects are not taken into account, then SRI will revert to the prehistoric ages in finance when, before Markowitzís research, one wondered whether all oneís money should be invested in the security that was best ranked by financial analysts. Being solely concerned with the individual qualities of securities means forgetting all that.

The goal of the FTSE EDHEC-Risk ERAFP Eurobloc SRI Index is therefore to reconcile a security selection approach with portfolio construction.

An index leads to talk of passive investment. Will SRI also succumb to the lure of passive investment?

NoŽl Amenc: These results show that efficient indices are less easy to beat than cap-weighted indices.

The analysis of fund performance shows that an efficient SRI index raises the bar for actively-managed SRI funds. While about 60% of funds have a positive information ratio when compared to the cap-weighted EuroStoxx Sustainability Index, only about 25% of funds do so with respect to the Efficient SRI Index. It is also interesting to note that the median information ratio across funds is slightly positive (0.05) when using the standard SRI index, but it is clearly negative (-0.22) when using the Efficient SRI Index.

Even though the track record is not extensive at this stage, these figures do provide the industry with food for thought, in the same way that efficient and minimum variance indices pose questions for active managers in terms of outperformance, track records and management fees. It is clear that the arrival of an efficient index in the SRI world should be an incentive to develop passive SRI investment.

It would no longer be a question of trying to achieve outperformance through an SRI approach that is designed to give a better forecast of the marketís valuation of stocks that that produced by traditional financial analysis, but of committing to the idea that once the stocks have been selected on the basis of strict SRI criteria, the best way to improve the portfolioís risk/return ratio is to optimise its diversification profile, thereby avoiding any ad-hoc portfolio construction scheme, whether based on capitalisation or SRI rating.

About NoŽl Amenc

NoŽl Amenc is professor of finance and director of development at EDHEC Business School, where he heads the EDHEC-Risk Institute. He is also chairman of EDHEC-Risk Indices & Benchmarks. He has a masters degree in economics and a PhD in finance and has conducted active research in the fields of quantitative equity management, portfolio performance analysis, and active asset allocation, resulting in numerous academic and practitioner articles and books.

He is a member of the editorial board of the Journal of Portfolio Management, associate editor of the Journal of Alternative Investments, member of the advisory board of the Journal of Index Investing and a member of the scientific advisory council of the AMF (French financial regulatory authority).

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