The KLD Select Social Index:
A Risk, Return and Performance Attribution Analysis

In June 2005, KLD celebrated the first anniversary of the KLD Select Social^SM Index (SSI). The Index is constructed to maximize exposure to positive social and environmental factors while exhibiting risk and return characteristics similar to those of the Russell 1000^®Index.

To construct the Index, KLD evaluates the social and environmental performance of companies in the universe by analyzing community relations, diversity, employee relations, human rights, product quality and safety, environment and corporate governance. KLD assigns ratings based on specific criteria within each issue.

Company ratings are translated into Issue Scores that are aggregated into overall Company Scores used to rank companies relative to sector peers. An optimization process uses the Company Scores as a factor in determining Index holdings and weights. The Index controls financial risk by constraining expected tracking error to less than 200 basis points relative to the Russell 1000.

The Select Social Index concentrates weights of holdings in companies with strong social and environmental performance. Companies with high Company Scores tend to have higher weights and companies with low Company Scores tend to have lower weights compared to the Russell 1000.

The risk, return and performance attribution analysis in this article offers new information about the Select Social Index's innovative approach to social investing for the first fifteen months of operation.

Table 1: SSI Cumulative Total Returns (June 2004 - August 2005)

Source: FactSet Research Systems

Since its inception in June 2004, the SSI under performed the Russell 1000 on a total return basis and on a risk-adjusted basis. The graph above shows the Cumulative Total Return of the SSI (10.64%) and the Russell 1000 (13.16%) for the past fifteen months.

Table 2: SSI Upside/Downside Capture (June 2004 - August 2005)

Source: FactSet Research Systems

Upside and Downside Capture Ratios measure the difference in return of the portfolio and the underlying benchmark during an up and down 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 SSI upside ratio of 89.90% indicates underperformance of its benchmark the Russell 1000, during market rises. The downside ratio of 101.47% indicates slight underperformance of its benchmark during market declines. The Index under performed the Russell 1000 by less in down markets than it under performed in up markets.

Table 3: SSI Performance Statistics (June 2004 - August 2005)

Source: FactSet Research Systems

Annualized Returns are the average return gained each year over one or more years. Annualized returns over the past fifteen months show that the SSI under performed the Russell by an average of 1.96% per year (8.43% versus 10.39%).

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 SSI standard deviation of 8.42 and the Russell 1000 standard deviation of 8.31 is 0.11, indicating the slightly higher risk associated with the SSI.

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 SSI tracking error signifies the likelihood that SSI annual returns will be within + or - 1.95% of the Russell 1000. The Index has a target tracking error limit of 2.00%.

Table 4: SSI Risk Statistics (June 2004 - August 2005)

Source: FactSet Research Systems

Beta is a measure of portfolio volatility relative to the benchmark of the portfolio. The SSI beta of 0.99 is highly correlated with fluctuations in the Russell 1000 and indicates a risk level slightly lower than the Russell 1000 benchmark.

Alpha measures the risk-adjusted performance relative to the benchmark of a portfolio, or the value added by the selection of stocks in the SSI. The SSI alpha of -0.14 demonstrates a performance marginally less than would be predicted given its beta. This statistic quantifies the average annual risk-adjusted return of the SSI relative to the Russell 1000.

The Sharpe Ratio is another measure of risk-adjusted performance calculated by dividing the excess annualized return of a portfolio above the risk-free rate by its standard deviation. The SSI Sharpe Ratio value of 0.75 is less than the Russell 1000 value of 1.00 and indicates lower annualized return per unit of risk.

R-Square is the measure of correlation between a portfolio and the benchmark. The SSI's value of .95 means than 95% of the variation in its price changes could be attributed to changes in the benchmark. The other 5% is attributable to a variety of factors.

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Performance attribution, a method of measuring the effects of stock selection and allocation, can help explain why the performance of the SSI differs from that of its benchmark. The performance attribution in Table 5 explains the impact of sector allocation. The Select Social Index over weights and under weights companies according to environmental, social and governance scores compared to industry peers. Sectors with higher average scores are thereby overexposed and sectors with lower average scores are underexposed. The SSI was hurt most by under-exposure to the energy and utilities sectors, both of which performed strongly in the time period.

Table 5: SSI Sector Performance Attribution (June 2004 - August 2005)

The Select Social Index comprises a strong representation of environmental, social and governance (ESG) factors. This is due to the Index selection and weighting process. The Index selects highly ranked companies from its universe, with 64% of selected companies coming from the top sector-quartile of KLD ratings. The Index then over-weights and under-weights the selected companies based on their relative ESG performance, with 90% of the index weight concentrated in the top sector-quartile of companies.

The weighted SSI score is greater than 95% of companies in the Russell 1000 and S&P 500. It also has much better risk characteristics than any single company because it is a diversified portfolio.

Table 6: Environmental, Social, and Governance Characteristics of the SSI

Conclusion

The innovative construction of the SSI provides additional data on the impact of social and environmental factors on risk and return. An analysis of risk and return explains the effects of over-exposure to sectors with higher ESG scores and under-underexposure sectors with lower ESG scores.

• Over the past fifteen months, sector under-weighting hurt the Index performance more than over-weighting helped.
• A strong representation of ESG factors can be achieved through an effective weighting process and risk management.

As the track record of the SSI grows, KLD will periodically report on its evolving risk and return profile.