SRI Performance: The Means and Ends¹

         The phrase “socially responsible investment” is unloved even by those who advocate it. But, it has a virtue. It highlights the poles of the concept’s dual nature: One should be socially responsible and one should be a responsible investor.

         Being an investor means being judged on one’s investments’ “performance”. Performance – of a number of types – comprises the ends of social investing. But what is this thing called “performance” and what means must we use to measure it? Those questions affect not just SRI investors.

The Poles of “Performance”

         In financial services people talk about “performance” as if it were absolute, timeless and commonly understood without adjectives. But, it’s not.

         In two general and twelve specialist dictionaries in finance, economics, business, accounting and law I looked to no avail for a working definition.

         I found what I sought in Capital Ideas, Peter L. Bernstein’s fine history of today’s financial theory. Describing the halcyon days before the 1973 bear market and institutional investors’ takeover of the equities market, he says.

        These two measures – “human satisfaction” and “comparative rates of return” – bracket the concept for values-based investors (and many others) and suggest a working definition of “investment performance”.

         Writing in 1980, those early SRI foes, John Langbein and Richard Posner admitted “human satisfaction” could be an element of performance:

         Langbein and Posner wasted little time on the individual investor’s right “to derive a consumption value”, but they fired on institutions that might look for the same thing.

         A moment’s reflection on pensions funded by arms of the Roman Catholic or Methodist Churches reveals the law professors’ overstatement. Indeed in explicitly rejecting Langbein and Posner’s views, the Maryland Court of Appeals 16 years ago said:

The court was interpreting a statute very much like ERISA. The ERISA administrator has expressed a similar standard for “collateral benefits” such as social screening.⁶

Trustees’ & Sponsor’s Roles

        Let’s assume the trust instrument’s silence on the subject of social investing. And, let’s assume that the question is strictly one of morals.

        The trustees have the discretion to decide whether “human satisfaction” or “consumption value” or “collateral benefits” will play any role in their investment decision-making process. The law is absolute, however, that they cannot substitute their personal objectives for the interests of the beneficiaries.

        Still, not a lot of beneficiaries would take pleasure in knowing their pensions profited from the sex trade. (One can guess the reaction of, say, the Salvation Army, to the news that a trust benefiting it held brothel bonds.) Nor would it be hard for the trustees to find replacements “having similar risks” among other leisure stocks.

        From there, the calculations of the beneficiaries’ interests and the merits of alternatives become more difficult, though not impossible. In all cases, the trustees must make the decision in the context of a discipline, a process.

        The creator of a trust, including a pension trust, can require the trustees to apply social screens. As with South Africa and now with Sudan, public plan sponsors can require by legislation the application of social screens.

        Many of the criteria commonly viewed as moral have dimensions that make them relevant in the investment decision-making process. The Anglo-German international law firm, Freshfields Bruckhaus Deringer concluded in a report in October that the links between environmental, social and governance (ESG) “factors are increasingly being recognised. On that basis, integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.”⁷

        Again, the trustees have the discretion to decide the weight to be assigned these factors. But these risks are not “collateral benefits” as the ERISA administrators phrase it.

        And so we return to Bernstein’s poles of performance: “human satisfaction” and “comparative rates of return”.

“Comparative Rates of Return”

        One of the profound changes in institutional money management since 1973 has been the necessity of comparing rates of return to a “benchmark”, a standard against which something is measured.

        The proper benchmark for a portfolio’s performance is an index that reflects how the market for similar securities did over the same period. Hence to gauge rates of return, a proper benchmark for broadly diversified, large cap equity portfolios would be the S&P 500 or the Russell 1000.

        An entire consulting business exists to serve institutions based on what they know about the risks and returns produced by managers. Beyond them are the Value Lines and Morningstars that offer means of comparing stock performance and mutual fund performance.

        Investment advisers typically observe standards for reporting performance that were developed by the CFA Institute.⁸ Its standards require that a manager’s performance be compared to a benchmark:

        SEC Form N-1A requires mutual funds to report their investment performance in comparison to “an appropriate broad-based securities market index....”¹⁰

Social Benchmarks & Benchmarking

        One commentator has argued, “The obsessive drive to compare SRI funds with conventional funds should cease. The difference in yield is largely irrelevant. What is relevant is what a company does, how it does it, and then, and only then, is yield relevant.”¹¹

        As we’ve seen, the SEC and CFA Institute disagree. The commentator’s argument lies with the investor protection structures constructed over the past 70 years. Of these, the ability to compare investment yields was a significant step forward in disclosure.

        However, on an “apples-to-apples” basis the rationale for using SRI benchmarks is compelling. And, the SEC offers some support in the instructions to its Form N-1A.

        In practice, social funds will always be compared to unscreened benchmarks. The SEC, consultants, Value Line, Morningstar and the business media dictate that. But socially screened funds and portfolios could – and should – be gauged against screened benchmarks, too. Fund managers and investment advisers (with a nudge from consultants) could dictate that choice.

        For individual investors who have only to answer to themselves, the question of yield can take a subsidiary position to a company’s social record. An astute trustee who recognized the 2001 California energy squeeze for what it was might have ordered Enron dropped from his/her portfolio regardless of the stock’s projected yield. No court would fault that decision.

        Still the reality remains: a court, a consultant and a client will all evaluate the trustee or manager at least in part on comparative performance.

A Trade Off?

        From a philosophical standpoint, values-based investors have, perhaps, lost something by the intrusion of comparative performance into their decision-making. After all, consistency between one’s portfolio and one’s ethics could hardly be more attuned with “human satisfaction”. But, the practical benefits comparability have conferred on the investing public – and on values-based investors – far outweigh any loss.

        For SRI investors and, indeed, all investors, the question is where between the poles of performance to affix their gauge.

¹ This article is adapted from his “‘Socially Responsible Investing’: An Evolving Concept in a Changing World” (2005)

2 All were published in the last 20 years by presses in the US and UK including MIT, Oxford, The Economist/Blackwell, Barron’s, West and the New York Institute of Finance.

3 Peter L. Bernstein, Capital Ideas (New York: Free Press, 1992), p. 10. Bernstein is a master of historical perspective, the telling anecdote and the lucid explanation of mind-numbing theoretical constructs. Few books are essential; this one is for anyone seriously interested in investing and the lenses through which economic arguments are passed.

4 John H. Langbein & Richard A. Posner, "Social Investing and the Law of Trusts", 79 Mich. L. Rev. 72, 94 (1980). As is true of most of the two scholars’ “economic” speculations, these were not inhibited by such fettering factors as data. In a recent review of his Catastrophe! Risk and Response (2005), Clifford Geertz captured the Posner essence: “...a hectic flurry of piled-up fact-bites, speculative calculations, passing quarrels, and offhand policy dicta – an orderless mixture of assertion, guess, remark, and opinion for which the term "farrago" would seem to have been invented....” Clifford Geertz, "Very Bad News" New York Review of Books, March 24, 2005, pp. 4, 6.

5 Id., p. 95 (footnote omitted). “[The] reader will not go far wrong if he understands social investing to be pursuit of an investment strategy that tempers the conventional objective of maximizing the investor’s financial interest by seeking to promote non-financial social goals as well.” Id., p. 73. So, Langbein and Posner assume (or assert?) that the maximization of shareholder value is the primary objective of investors. In this context, they make no concession to factors such as risk or risk-tolerance that might convince an investor to seek less than maximal returns.

6 Bd. of Trustees v. Mayor of Baltimore City, 317 Md. 72, 562 A.2d 720, 737 (1989), cert. den. sub nom. Lubman v. Baltimore City, 493 US 1093, 107 L.Ed. 2d 1069, 110 S.Ct. 1167 (1990). (Citation omitted.) The court quoted J.C. Dobris, “Arguments in Favor of Fiduciary Divestment of ‘South African’ Securities”, 65 Neb. L. Rev. 209, 232 (1986). This case is the only one dealing with SRI and fiduciary duties to be decided by a court of last resort in an English-speaking jurisdiction. Its significance is described in “Pensions & the Companies They Own”, op. cit., pp. 30-33.

7 “Calvert Letter”, PWBA Office of Regulations & Interpretations, Advisory Op. 98-04A, May 28, 1998 http://www.dol.gov/ebsa/programs/ori/advisory98/98-04a.htm

8 Freshfields Bruckhaus Deringer, A Legal Framework for the integration of environmental, Social and governance Issues into Institutional Investment (New York/Nairobi: United Nations Environmental Programme Finance Initiative, 2005), p. 13.

9 Formerly the Association for Investment Management & Research (AIMR).

10 Association for Investment Management & Research Performance Presentation Standards (AIMR PPS) (May 20, 2001) §5.A.7. http://www.cfainstitute.org/standards/pps/PPS_outline/content.html#present

11 US Securities & Exchange Commission Form N-1A, §22(b)(7)(ii)(A), p. 50. http://www.sec.gov/about/forms/formn-1a.pdf

12 Paul Hawken & The Natural Capital Institute, “Socially Responsible Investing” (Sausalito, Calif.: Natural Capital Institute, Oct. 2004), p. 28. http://www.naturalcapital.org/images/NCI_SRI_10-04.pdf Hawken’s final assertion is wrong. As discussed above, AIMR and the SEC require such comparisons.

13 US Securities & Exchange Commission Form N-1A, §22(b)(7)(ii)(A), Instruction item 6, p. 51. http://www.sec.gov/about/forms/formn-1a.pdf. See also the discussion in the preceding section.

.