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Book Review--Profitable Socially Responsible Investing?: An Institutional Investor's Guide

Thursday, August 4, 2005
by William Baue

An invaluable tool for fiduciaries considering SRI, the book advances original research finding competitive financial performance for positive screening. -- Sitting down to lunch at this year's Green Mountain Summit on Investor Responsibility in Stowe, Vermont, a socially responsible investing (SRI) conference, the woman in the next seat introduced herself as Maya Gladstern, a Marin County Employees Retirement Association (MCERA) trustee. As a fiduciary responsible for county pension fund investments, she asked, "Are there any resources available explaining all the issues we trustees have to take into account to consider applying SRI?"

Soon thereafter, book Profitable Socially Responsible Investing?: An Institutional Investor's Guide arrived in the mail. The book is a vital tool for institutional investors looking to conduct prudent and comprehensive due diligence in considering SRI, as it systematically addresses the most pressing questions.

Does fiduciary duty preclude SRI? No, according to Mr. , who is something of a Renaissance man as a lawyer, certified investment specialist, and university professor who has authored more than 30 books. Mr. surveys the legal landscape, a "crazy quilt of Federal and state statutes, common law precepts, and judicial opinions" including Employee Retirement Income Security Act (ERISA) and the Uniform Management of Institutional Funds Act (UMIFA).

"Professor Austin Wakeman Scott famously observed that it is 'well settled' that trustees are permitted to take the social behavior of corporations into account when they made investment decisions," writes Mr. , noting however that Prof. Scott does not cite "binding legal authority for his view."

Mr. cites the US Department of Labor (DOL) 1998 ERISA letter to Calvert sanctioning SRI for corporate pension funds, but he does not cite the 1989 Board of Trustees v. Mayor of Baltimore City case allowing consideration of "the social consequences of investment decisions."

Helpfully, the book reprints several SRI investment policy statements, including 2 Quaker groups--American Friends Service Committee (AFSC) and Canadian Yearly Meeting (CYM)--and the Jessie Smith Noyes Foundation. It also reprints several questionnaires Mr. uses at his investment firm, which help gauge investors' negative and positive screening preferences as well as proxy voting priorities.

The question Mr. spends the most time addressing, as the interrogative title suggests, is the issue of SRI returns. He surveys the literature of academic and professional empirical research, pointing out some "serious methodological flaws," such as the use of linear regression or the misattribution of causation to mere correlation where other factors could impact performance.

The bulk of the book advances Mr. original research, which examines the financial impacts first of negative screening and then of positive screening.

His findings? Portfolios of alcohol, tobacco, and gaming industries all outperformed the S&P 500 (and the defense industry kept pace) during the period studied (January 1995 through December 2003, which included a full economic cycle). So negative screening (which excludes these industries from portfolios) drags on risk-adjusted returns, Mr. found.

Portfolios created through positive "best-in-class" screening, which screens in companies with best practice on social and environmental responsibility, all outperformed Mr. benchmark of 2884 stocks from the Russell 3000 during the period he studied.

Mr. characterizes his findings as "provocative," and they certainly make an valuable contribution to the body of empirical research on SRI financial performance. However, Mr. cautionary words about many of the existing studies (which are "funded or prepared by partisans who seek to promote corporate social responsibility, SRI, or both") can be applied to his work. Some of Mr. methodology is proprietary, and of course Mr. runs an investment business, so he is no more impartial than those whose research he cautions his readers to view skeptically.

Mr. reveals a bias early on. He focuses his research on stocks and explains that mutual funds are outside the purview of his study, a fair enough limitation from a methodological perspective. However, he adds to his methodological rationale for this exclusion a practical (or perhaps philosophical) bias against mutual funds: needing to appeal to a broad range of investors, fund managers include companies in their portfolios with tarnished social and environmental records.

"A company known for its progressive social justice policies, for example, might pollute and disrespect the environment," Mr. writes. "Another company that is an excellent steward of the environment might have a poor record on diversity, human rights, or employee relations."

"The fund managers commend this or that aspect of their social or environmental performance, while ignoring their bad behavior in others," he adds.

Hence separately managed accounts are superior SRI vehicles compared to SRI mutual funds, because the former can tailor portfolios to meet investors' idiosyncratic values, according to Mr. . True enough, but what Mr. elides is the fact that the very same dilemma facing fund managers faces separate account managers--that their portfolios inevitably contain less-than-perfect companies.

A more primary factor distinguishing mutual funds from separate accounts is the economic class of the client, as separate accounts are geared toward high net-worth individuals and institutional investors while mutual funds are geared to everyday investors. It is perfectly legitimate for Mr. to focus on separate accounts because his book is geared toward institutional investors. It is quite another thing, unfortunately, that he introduces an unnecessary and spurious distinction to discredit mutual funds.

This is not to say that Mr. findings are necessarily faulty--indeed, presenting his results in book form gives him plenty of space to stretch out and explain methodological details and potentially confounding factors in depth, enhancing the robustness of his conclusions. Simply put, however, we readers must take his findings with the same grain of salt as he sprinkles on others' research.




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