KLD's Domini 400 Social Index At 15:
A Risk and Return Analysis

In May 2005, KLD celebrated the 15th anniversary of the Domini 400 Social^SM Index (DSI). As the first benchmark for equity portfolios subject to multiple social screens, the DSI provides the most complete and definitive data available on the financial performance of socially screened portfolios. While the performance of the Index has varied with market cycles, returns over the past 15 years show that it has outperformed the S&P 500® (S&P), a widely accepted benchmark for the overall U.S. market. On April 30, 2005, 246 of the holdings in the DSI were also in the S&P 500.

From its conception, one of the DSI's major purposes was to foster a greater understanding of the investment implications of social screening. KLD remains committed to that goal. The risk and return analysis in this article offers new information about the DSI's financial characteristics and behavior.

Table 1: DSI Cumulative Total Returns (May 1990 – April 2005)

Source: FactSet Research Systems

Click here for corresponding data table

Since its inception in May 1990, the DSI outperformed the S&P 500 on a total return basis and on a risk-adjusted basis. The graph above shows the Cumulative Total Return of the DSI (438.79%) and the S&P 500 (381.89%) for the past fifteen years.

Table 2: DSI Multi-Period Annualized Returns (May 1990 – April 2005)

Source: FactSet Research Systems

Annualized Returns are the average return gained each year over one or more years. The multi-period annualized returns chart above shows the annualized returns for different time periods throughout the DSI’s history, beginning with the most recent year. Annualized returns over its first 15 years show that the DSI outperformed the S&P by an average of 0.83% per year (11.88% versus 11.05%).

Table 3: DSI Upside/Downside Capture (May 1990 – April 2005)

Source: FactSet Research Systems

Upside and Downside Capture Ratios measure the difference in return of the portfolio and the underlying benchmark during an upside and downside market, respectively. Upside capture is defined as the ratio of the cumulative monthly portfolio return to the cumulative monthly benchmark return when the market rises; downside capture is similarly defined as the ratio of the cumulative monthly portfolio return to the cumulative monthly benchmark return when the market declines.

The DSI's upside ratio of 119.56% indicates significant out-performance of its benchmark, the S&P 500, during market rises. The downside ratio of 100.69% indicates slight underperformance of its benchmark during market declines. The Index outperformed the S&P by more in up markets than it underperformed in down markets.

Table 4: DSI Performance Statistics (May 1990 – April 2005)

Source: FactSet Research Systems

As mentioned above, the DSI's Annualized Return over a 15-year period is 11.88%, compared to 11.05% for the S&P 500.

Annualized Standard Deviation measures the average deviations of historical annual returns from the mean of the data set. It is often used as one measure of risk, as a larger standard deviation implies larger swings in the portfolio returns. The difference between the DSI's standard deviation of 15.45 and the S&P’s standard deviation of 14.50 is 0.95, indicating the slightly higher risk associated with the DSI.

Tracking Error measures the amount by which the performance of the portfolio differs from that of the benchmark. It is defined as the standard deviation of returns relative to the benchmark. The DSI's tracking error signifies the likelihood that DSI annual returns will be within + or – 2.95% of the S&P 500.

Table 5: DSI Risk Statistics (May 1990 – April 2005)

Source: FactSet Research Systems

Beta is a measure of portfolio volatility relative to the benchmark, or the systematic risk of the portfolio. The DSI's beta of 1.05 is highly correlated with fluctuations in the S&P 500 and indicates a risk level slightly higher than the S&P 500.

Alpha measures the risk-adjusted performance relative to the benchmark of a portfolio, or the value added by the selection of stocks in the DSI. The DSI’s alpha of 0.03 demonstrates a performance marginally better than would be predicted given its beta. This statistic quantifies the annual risk-adjusted return of the DSI relative to the S&P.

The Sharpe Ratio is another measure of risk-adjusted performance calculated by dividing the excess return of a portfolio above the risk-free rate by its standard deviation. The DSI's Sharpe Ratio value of 0.50 is greater than the S&P 500's value of 0.47 and indicates greater return per unit of risk.

The Information Ratio measures the ratio of expected return to risk, relative to a benchmark. It is calculated by taking the excess annualized return over the benchmark and dividing it by the tracking error (see above definition). The DSI’s information ratio of 0.28 demonstrates the added risk-adjusted performance relative to the S&P 500.

R-Square is the measure of correlation between a portfolio and the benchmark. The DSI’s value of 0.97 means than 97% of the variation in its price changes could be attributed to changes in the benchmark. The other 3% is attributable to a variety of factors.

Conclusion
KLD created the DSI in part to evaluate how social screening affects portfolio characteristics and performance. Fifteen years of data, representing 180 monthly observations covering a broad range of market conditions, provide valuable information for assessing this impact.

• The DSI has outperformed the S&P 500 in absolute and risk-adjusted returns over the past 15 years (as measured by alpha and the Sharpe ratio).
  
  
• The additional risk in the DSI reflects differences introduced by the index construction process in which the selection of holdings is determined by social and environmental screens. This risk results from differences in:
  
  - Holdings (S&P companies not held and non-S&P companies held in the DSI)
  - Factor characteristics (capitalization, style, etc.)
  - Sector Allocation
  
  
• DSI performance varies from that of the S&P as the market moves up and down. The DSI tends to outperform the S&P in up markets more than it underperforms the S&P in down markets.
  
  
• The DSI behaves differently from the S&P over the stages of economic and stock market cycles. The DSI outperformed the S&P in absolute terms in 9 of the first 10 years (May 1990 to April 1999) and in 3 of the most recent 5 years (May 2000 to April 2005).

The DSI continues to fulfill the part of its mission directed at helping investors understand how social screening affects the risk and return characteristics of screened portfolios. We anticipate learning even more over the next 15 years.