By Alan Petrillo In 2008, KLD celebrates its twentieth year as an independent provider of investment research. From this perspective on the practice of socially responsible investing (SRI), KLD is reflecting on what we’ve learned. How have companies incorporated SRI principles into their operations? On what environmental, social and governance (ESG) factors have corporations made the most progress?  Which issues remain points of contention between management and other stakeholders, including investors, employees, and the community? For 16 years, Tom Kuh has been one of KLD’s thought leaders.  In this article, we’ll explore his views on how SRI has evolved, and how KLD has both shaped that evolution and responded to it. Tom’s Background Thomas Kuh, Ph. D, is Managing Director of KLD Indexes, a division of KLD Research & Analytics, Inc. He was a Research Analyst at KLD from 1992 to 1995, evaluating the social and environmental records of companies and consulting on related issues with institutional money managers and investors. From 1995 to 1998, he was Product Manager for SOCRATES, the first database application providing social investment research and portfolio screening tools. From 1998 to 2004, he was Director of Business Development at KLD. To learn more about Tom Kuh, please see his bio at kld.com. Also read an interview with Tom and KLD President Peter Kinder at Index Universe.

I. KLD’s Role, Then and Now

When KLD launched the Domini 400 Social Index (DS400) in 1991, both advocates and critics alike saw socially responsible investing as a specialized niche of the retail investment world. “SRI was a purely values-based enterprise,” Tom says. “It was a relationship between an individual and his portfolio.”

In creating the first benchmark social index, KLD sought to enable comparisons of SRI portfolios with unscreened portfolios.   KLD based the DS400 on the S&P 500, which serves as institutional shorthand for the overall market of large-cap US stocks.

“It was a timely concept,” Tom explains. “The DS400 established a benchmark; it generated risk and return information that nobody had before.” For KLD, ongoing maintenance of an index indicated a level of expertise and commitment that attracted wider notice. Tom says that this helped make KLD “more serious than our competitors in the eyes of the mainstream investment world.”

The DS400, like all KLD indexes and research products, depends on reliable and timely information about how corporations conduct business. KLD compiles information from media and third-party sources, but also relies on companies’ disclosure of their environmental, social and governance (ESG) performance.

In 2008, investors can expect corporations to issue sustainability reports that follow agreed-upon reporting guidelines. This wasn’t always the case.

“In the beginning, we had to solve a scarcity problem,” Tom says. “One of KLD’s key contributions was a process for generating real information about risk and performance. When we first started publishing, a profile might have been two or three pages long. Companies were not reporting on this sort of performance.” Maintaining an issue file in 1991 meant clipping articles from the Wall Street Journal and other publications, and filing them in manila folders.

Times have changed, and not simply because of better ESG reporting. The internet has revolutionized the gathering and management of investment research. “The economics of information has changed. Collecting and distributing it is much cheaper than it used to be,” Tom says.

 KLD’s SOCRATES database today consists of detailed profiles of more than 3,000 companies, evaluated on over 280 data points. A team of analysts tracks each company’s performance on issues including community relations, corporate governance, diversity, employee relations, human rights, product safety, and the environment.

“The growing sophistication of clients, and the sheer volume of data out there, means that we’re expected to analyze information, rather than just cataloging it,” Tom says. “In addition to ‘What does a company do?’ we now have to answer, ‘How do they do it?’”

II. Institutional Investors: Serving a New Kind of Client

Over the past five years, institutional investors have driven substantial growth in SRI assets. KLD has developed research products that serve the needs of investment fund managers and advisors, as well as individual SRI investors.

Institutions share one crucial concern with individual SRI investors: performance. Values-driven investors still seek high returns. “I like to say, ‘It’s investment, stupid,’” Tom says, laughing. “Performance is always an issue.” 

Tom explains a crucial difference between individual and institutional investors: with institutional clients, “it’s never clear if there are social objectives involved.”

“This sort of investing [SRI] started with an individual perspective on things – not an institutional perspective – because individuals aren’t bound by narrow interpretations of fiduciary duties. The industry has struggled with the perspective of institutional investors, because they keep some distance from questions about values.”

KLD developed its Global Sustainability Index (GSI) series with institutional investors in mind. Fund managers seek to manage exposure to risk, which means a diversified portfolio of best-of-breed companies across all asset classes. The GSI, launched in 2007, is a broadly diversified, sector-neutral global benchmark index. Sector neutrality limits the financial risk associated with sector bias, which can be a risk of some SRI strategies. The GSI holds companies with the highest sustainability rankings in each sector in each region.

Sustainability refers to the degree to which companies address the social and environmental needs of the present without compromising the quality of life of future generations. KLD rates a company’s sustainability performance by analyzing key ESG factors: environment; community and society, employees & supply chain customers; governance & ethics.

Does this represent a departure from how KLD constructed its previous indexes?  “Not at all,” says Tom.  KLD still evaluates a company’s involvement with issues traditionally subject to SRI screens such as military, alcohol and gambling.  “But the way in which we evaluate and analyze these issues in relation to the company’s performance and the greater societal impact has changed.”

Is this change partly driven by institutional managers’ priorities?

“Oh, absolutely,” Tom says. “We’re valuable to clients because we know something they don’t. They don’t want to become experts. They want us to provide info to help them do their jobs. They don’t necessarily care deeply [about SRI issues] and they shouldn’t have to.”

An individual might wish to exclude all oil companies, for example, from his or her portfolio. Many institutional managers avoid such a proscriptive approach, opting instead to select companies within an industry that outperform their peers on relevant ESG issues. As Tom explains, “Our clients ask that we evaluate oil companies. A manager or a trustee needs information on how these companies perform, good and bad. We can’t just say, ‘We can’t do that.’  SRI has never been a one-size-fits-all approach.”

III. Concerns, Developments, Reflections

Has SRI joined the mainstream – or has the mainstream joined SRI?  It’s probably the latter – or at least, it’s now common for the financial services industry to acknowledge SRI concerns. Many larger, older research and management firms have entered the marketplace. Inevitably, this expansion has led to a proliferation of descriptive terms and some confusion as to what SRI really entails. Lack of clear, broadly accepted definitions could lead to confusion, or worse; like “all-natural” or “healthy,” marketing terms like “sustainable” could be applied so loosely as to mean nothing at all.

 “The language has always been a problem,” Tom says. “[KLD co-founder Steven] Lydenberg used to refer to what we do as ‘Corporate Accountability’ research. What does a concept like ‘sustainability’ mean? We think we should help define that,” both for the industry and the public. For KLD’s definitions of these and other relevant terms, see the Glossary and our Resource Page.

Whose Values?

What motivates the values-driven investor? While SRI investors share many concerns, other issues inspire disagreement. KLD’s Catholic Values 400 (CV400) Index highlights some of these contentious issues. Based on the DS400, the CV400 has an additional layer of screens covering abortion, contraceptive products and embryonic/fetal stem cell research.

The CV400 was created in response to demand from firms that serve large Catholic organizations. It is a benchmark index that captures the effects of the NCCB guidelines on a large-cap portfolio. The Church’s position on these issues may conflict with those of other KLD clients, but SRI has never been an ideological monolith.

There is no one set of SRI values; there isn’t even one way to do Catholic investing. “Remember, some of the first SRI actors came from religious organizations,” Tom explains. “On one hand, you might have a small religious order that’s opposed to war on principle; on the other you have the Archdiocese of Boston. Their investment goals, and their SRI methods, may have different emphases. All maintain compliance with the investment guidelines of the National Conference of Catholic Bishops (NCCB).”

The Question of Materiality: Is it Material?

The Financial Accounting Standards Board defines “materiality” as:
"The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement."  The drafters of the Securities Acts deliberately did not define “material.”  They recognized that materiality changed over time under particular circumstances.  They left the definition of materiality to the SEC and the courts.

“Material” refers to what an investor needs to make an informed decision to buy, sell or hold a particular security.  The company has a duty to anticipate the investor’s needs. In reference to SRI, the question of materiality involves management’s obligation to report on corporate response to climate change, or performance on other ESG criteria. Since these criteria may be non-financial, is disclosure still necessary? Is a failure to report on ESG performance an omission that rises to the level of materiality?

In Tom’s opinion, “The materiality debate – which is really a question about corporate reporting –is a sign of SRI’s involvement in the mainstream. Materiality is one element of the equation. It’s a problem if that’s all that SRI is reduced to, but it’s the right question to ask.” The question of materiality revolves around, first, whether SRI data affects the investor’s decision-making and, second, as to whether the data correlate to financial performance.  In KLD’s view, the former is far more important than the latter.

“There’s a problem if institutions say that SRI should pass or fail based only on the financial materiality question,” Tom says.  Material information could be defined as short-term financial metrics, such as stock price fluctuations or the quarterly bottom line.  Most proponents of sustainable or social investing advocate a longer-term perspective.  Many of the issues that social investors consider material wouldn’t immediately affect financial performance.  While SRI performance can be hard to quantify, a growing body of research is beginning to identify and analyze the impact of non-financial performance on corporate competitiveness.

KLD and the Mainstreaming of Accountability

Since 1988, socially responsible investing has become mainstream. Marking this arrival is that SRI issues such as environmental protection attract attention at every level of society.

KLD’s work has also grown because investors are demanding more information on all aspects of corporate behavior.  For example, abusive lending was a concern for KLD even before the recent housing crisis.