About Portfolio Screening

Portfolio screening: What is it?
Screened portfolio investment: What can it accomplish?
Screened portfolio Investment: Can it assure consistency with mission?
Screened portfolio investment: What issues can it touch?
Screened portfolio investment: How and what does it communicate?
Screened portfolio investment: What goes in the investment policy?
Screened portfolio investment: Does divestment do any good?
Are there studies on screening's effect on the performance of U.S. equities?
Are there studies on non-U.S. equity portfolios?
Are there any studies on screened bond portfolios?
What conclusions can be drawn about screened portfolio performance?

Portfolio screening: What is it?

A screen is a criterion used in the process of making an investment decision. A screen may reflect the standards of financial quality a potential investment must meet. Or, it may reflect non-financial criteria, such as a manager's specialization, in, say, large capitalization companies or Pacific Rim equities.

Screened portfolio investing is the application of social criteria (or social screens) in investment decisions about conventional investments, such as stocks, bonds, and mutual funds. These criteria augment the institution's financial criteria; they should neither replace nor weaken them.

A social screen is a non-financial criterion that augments an investor's financial standards and reflects the investor's social, ethical, or religious concerns. In mission-based investing, the institution's mission defines the parameters for the social screens. The effect, if any, on investment performance of the application of particular social screens remains an open question. But in the authors' view, the evidence -- index performance, fund performance, scholarly studies -- appears to indicate that social screening does not require an institution to sacrifice performance. See Part VI, The Performance of Screened Portfolios.

Screened portfolio investment: What can it accomplish?

Portfolio screening has two objectives: consistency and communication. Thus:

An example of the first objective might be a foundation concerned with land-use issues which found owning shares in developers of agricultural land, such as Wal-Mart and Home Depot, inconsistent with its mission and decided not to buy them. The second objective is more subtle yet more important: to make a public statement of its mission in a financial context.

Screened portfolio Investment: Can it assure consistency with mission?

Not absolutely. Companies change; so do institutions. In both cases, change comes gradually, and an inconsistency between mission and an investment emerges slowly.

For instance, some years passed between the first stories about U.S. sportswear companies' subcontractors in southeast Asia and the Archipelago and decisions to divest companies such as Nike. Because social investors recognize that companies are not perfect, in such situations they often try to work with a company through dialogue or shareholder actions for change. If they don't succeed, they may divest in order to align their portfolios and their values.

In the end, screening works toward institutional consistency but it cannot guarantee it. The benefits from communication with the public and the companies make the effort worthwhile, even though the means are less than perfect.

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Screened portfolio investment: What issues can it touch?

In certain areas, screening can assure that an institution's domestic investments are not inconsistent with its mission. For example, a hospital may regard profiting from tobacco as at odds with its healthcare mission. Harvard and Johns Hopkins reached this conclusion, even though their overall educational mission includes more than health care.

It is relatively easy to screen out the main companies in the lines of business covered by the exclusionary screens such as alcohol, gambling, tobacco, military contracting, nuclear power and firearms. The most difficult questions involve tangential businesses. Was 3M in the business of selling tobacco when its outdoor advertising subsidiary sold billboard space for cigarette ads? Are groceries that sell beer, snuff, and scratch tickets in the business of selling alcohol and tobacco products and gaming chances?^*

Beyond the basic exclusionary areas, screening becomes more difficult. The exclusionary screens usually have clear-cut answers: a company makes cigarettes or it does not. For the other type of screen -- qualitative screens -- a "yes" or "no" is rarely an appropriate answer. In these areas companies can have negatives or positives or both.

Qualitative screens are sometimes used affirmatively. Some institutions seek to invest in companies that advance their mission. An environmental group might include in its investment guidelines a preference for companies selling ecologically sound products.

By their nature, qualitative screens require a nuanced evaluation of a company's performance. Evaluating the relationship between a company and the environment in which it operates poses difficult questions for researchers and investors. Qualitative screening becomes harder if the companies are multi-nationals or are not subject to U.S. reporting requirements, thus limiting the information available on their operations.

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Screened portfolio investment: How and what does it communicate?

Portfolio screening is a means of communicating with an institution's constituents and with companies.

Communications with constituents usually occur in the process by which the institution develops its screening policy and then in periodic (usually annual) reviews of the policy and its results. This type of communication is described above. Communication with companies occurs in two contexts: first, in the process of screening, itself; and second, in specific instances where a company's conduct is of concern.

In order to screen, an investor needs information. Directly or indirectly, the main source of that information will often be the company itself. Companies pay attention to the requests and questions they get from shareholders or potential investors. They also heed the queries they receive from research firms, because the questions represent those of the firms' clients who are primarily institutions.

In the context of mission-based investing, companies certainly know the social research firms and the clients they represent. They are aware of and respond to the issues that concern these investors. To respond, of course, does not imply a commitment to change. But it does acknowledge receipt of the communication. The information received by research firms often goes into reports which they provide to their clients. Most research firms ask a report's subject to review it before publication. Again, the company hears what investors' concerns are and has an opportunity to respond.

Investors who hire a manager specializing in SRI or who buy a socially screened mutual fund achieve the same objectives when the manager or the fund puts questions to a company. Of course, investors have an on-going responsibility to communicate their social concerns to their managers or fund management. Supervision on social issues should not end with hiring. A 1998 survey by the AFL-CIO revealed that two union pension fund managers had failed to follow substantive guidelines on how to vote proxies.^*

In out-of-the-ordinary situations, an institution may feel it must communicate directly with a company. But, that end is not required, even if the company fails to respond satisfactorily. Options range from doing nothing apart from registering displeasure to filing a shareholder resolution. The types of statements made through screening or direct expressions of concern let companies know the standards to which they are being held. They affirm for the public, an institution's constituencies, and the institution itself the value of its mission for society.

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Screened portfolio investment: What goes in the investment policy?

An investment policy is a written statement of an institution's objectives for its portfolio. A policy statement may include general guidance for implementing social investment objectives. The statement may simply require that the institution's funds "be invested consistently with our mission." Indeed, statements of a mission-based policy should be kept simple.

In most cases, a set of working guidelines (usually devised by a board's investment committee) will amplify the general statement in the investment policy. The working guidelines might include:

Since managers will use working guidelines in their day-to-day decision-making, clear examples and brightly drawn lines are important.

A few institutions require managers to submit proposed buy lists for screening. Others provide their managers with restricted lists, the names of companies whose securities a manager may not buy. Still others require their managers to work with a screening consultant. But, most place the responsibility for screening on their managers.

Screened portfolio investment: Does divestment do any good?

Divestment -- the selling of certain types of shares on principle -- can be an end in itself by bringing a portfolio into conformity with an institution's mission. It can also make a powerful statement.

Divestment affords institutions an opportunity to educate their constituencies and the public at large, just as the American Medical Association has done since it decided to divest its holdings in tobacco companies. These educational opportunities are ongoing. Each year when a board reexamines, say, its policy on alcoholic beverage manufacturers, it has an opportunity to communicate with its constituencies and the companies in question.

The argument against divestment is that it has no effect on the markets, the divested companies' stock prices, or their cost of capital. While essentially true^*, this argument misses the point. Decisions made around divestment alter how institutions and their stakeholders discuss investments. Divestment can also shift attitudes in the broader world of investors, as it did on South Africa.

Another argument against divestment is that companies welcome the departure of dissenting shareholders. In some circumstances (e.g., South Africa) and with some industries (e.g., gaming), remaining as a shareholder offers fewer opportunities to effect change than does joining the chorus of investors refusing hold such companies securities. That chorus is heard well beyond Wall Street, on streets where other types of pressures can be applied. Hence, the importance of making the statement. However, for companies, such as Intel, which listen to shareholders even when they dislike what they hear, divestment usually isn't as good an option as shareholder activism.

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Are there studies on screening's effect on the performance of U.S. equities?

Yes. Some studies have indicated that investors applying social criteria need not expect to lose anything vis a vis the broad market indexes. Appendix D, Resources, provides starting points for a literature review. The citation for the articles discussed below will also be found there.

In 1993, S. Hamilton, et al., reported in Financial Analysts Journal on their studies of socially screened mutual funds. They concluded: "Investors can expect to lose nothing by investing in socially responsible mutual funds [when compared to a benchmark of randomly selected mutual funds]."

In 1995, M.A. Cohen, et al., of Vanderbilt University reported that between 1987 and 1989 Green investors, who typically have quite stringent screening criteria, did not seem "to pay a premium for their convictions" as compared to the S&P 500.

In a 1997 study in The Journal of Forecasting, John B. Guerard, Jr., then Director of Quantitative Research for Vantage Global Advisers, reached a similar conclusion. Guerard compared the performance of Vantage's 1,300 company universe against a subset of 950 that passed four major screens: military; nuclear power; product exclusion (alcohol, tobacco, and gambling); and environment. Mr. Guerard found:

The Vantage Global Advisers' unscreened . . . universe produced a 1.068 percent monthly average return during the January 1987-December 1994 period, such that a $1.00 investment grew to $2.77. A corresponding investment in the socially-screened universe would have grown to $2.74, representing a 1.057 percent average monthly return. There is no statistically significant difference in the respective return series. More importantly, there is no economically meaningful difference between the return differential. (Emphasis added.)^*

Articles collected in the Winter 1997 Journal of Investing, including one by Mr. Guerard, confirm his conclusion. In "Additional Evidence on the Cost of Being Socially Responsible," Mr. Guerard concluded that the use of a broad range of social screens produces a more efficient portfolio than one that is only divested of tobacco stocks. He found that the use of environmental, product (alcohol, tobacco and gambling), military, and nuclear power screens produced portfolios with higher excess returns than unscreened portfolios. Of these screens in isolation, only the military screen significantly diminished returns between 1992 and 1997.

Are there studies on non-U.S. equity portfolios?

Yes. ^** In April 1998, Stephen Williams of the WM Company submitted a masters thesis to the University of Edinburgh illustrating various types of "ethical indexes" modeled on existing Financial Times broad market gages. These studies indicate performance similar to the Domini 400 against the Standard & Poor's 500.

Frank J. Travers of Oppenheimer & Co. studied 23 screened portfolios which he described as non-U.S. His Winter 1997 article in The Journal of Investing, "Socially Responsible Investing on a Global Basis: Mixing Money and Morality Outside the U.S.," concludes that over the periods he studied, these portfolios outperformed Morgan Stanley's EAFE Index and produced competitive returns to a universe of unrestricted portfolios.

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Are there any studies on screened bond portfolios?

To date, the only study on screened bond portfolios is one by Louis D'Antonio, Tommi Johnsen, and Bruce Hutton of the University of Denver. Their article, "Expanding Socially Screened Portfolios: An Attribution Analysis of Bond Performance" appeared in the Winter 1997 issue of The Journal of Investing.

They posed the question: could one develop a bond index with screens identical to the Domini 400's and, if so, how would it perform? They concluded that an analogue to the Lehman Corporate Bond Index could be constructed based on the Domini 400's constituent companies. As to performance, they concluded:

A portfolio of bonds comprising issues from firms represented in the Domini 400 performs comparably in terms of risk-return to the Lehman Brothers Corporate Bond Index. The SRI and LCB indexes are identical in the exposures to term structures. There is no significant difference between the portfolios . . ..

While the active returns for the SRI portfolio indicate that it outperformed the LCB index on a simple return basis, the premium appears to be related to differences in credit risk. In general, our research indicates that . . . there should be no penalty [to socially responsible investors] for following their social values after adjusting for credit risk.^*

What conclusions can be drawn about screened portfolio performance?

The performance of the Domini 400 and the results of the studies discussed above shift the burden of proof to critics to show that there are indeed "costs" to social screening. Thus far there appears to be little evidence that social screening necessarily results in lost return. The affirmative case for screened portfolios has not yet been proven. Time and a full market cycle will determine the "cost" question. But, the ultimate questions remain unresolved:

Late in 1992, BARRA published an analysis of the performance of the Domini 400 Social Index versus that of the S&P 500. Its conclusions, in part, were that:

[The] bulk of the outperformance [of the DSI versus the S&P] arises not from the factor biases inherent in the introduction of social screens, but from the specific asset return itself. There is a specific return premium to the index over this time period which is presumably related to the social screens KLD has developed, though the 95% confidence level is not quite statistically significant.^* [Emphasis added.]

Whether this and similar preliminary analyses will hold true remains to be seen.

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