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SRI and indexing no longer a mismatch

Index investing traces its roots back more than 50 years and socially responsible investing (SRI)—a child of the 1970s—is no spring chicken either. Yet only recently have the two investing strategies become integrated in a way that does justice to both.
 
Investing with goals beyond profits alone has traditionally meant giving up conventional indexing strategies. SRI, in essence, is an active investment strategy, which leaves little if any room for the passive notions of buying stocks and puts it at odds with tapping indexing's low costs and competitive returns.
 
Ray Jubitz, executive director of the Jubitz Family Foundation in Portland, Oregon, says he also used to get frustrated with the traditional brokerage community and what he recalls as a lack of respect for his SRI objectives.
 
The good news is that indexing no longer demands compromising on social, environmental or other values-based issues.
 
Combining passive investing with SRI in concept has been around for years in terms of creating new benchmarks from scratch. In 1990, KLD Research & Analytics created the first socially responsible equity index: Domini 400 Social, the target benchmark for the iShares KLD 400 Social Index, a US-listed exchange-traded fund.
 
What's new is the ability to unite an investor's specific social preferences with the risk and reward profiles of conventional indices. As a result, investors can target the standard market indices that everyone knows and still remain true to their socially responsible principles.
 
Customising SRI preferences around standard indices is still a niche area, so only a handful of firms offer the service. One well-known player is Parametric Portfolio Associates, an investment management shop in Seattle, Washington. Another is California-based Aperio Group.
 
One of Aperio's specialties is building customised index-based portfolios for institutional investors, family offices and top-end wealth managers. The firm's proprietary strategy lets you keep your SRI preferences while hugging the returns of an existing index.
 
Here's how it works. You choose an index, which can be almost any conventional benchmark. Let's say you generally like the prospects for the S&P 500 but you prefer to stay true to a particular set of values on, say, the environment.
 
Aperio translates your values preferences into a screening process that ranks companies in the S&P 500. At the same time, it minimises what's known in the money management trade as tracking error. In other words, the firm reengineers the index to satisfy your social objectives while otherwise giving you the return of the benchmark.

You'll still own a representative sample of the S&P 500 stocks, although in different weights, depending on your preferences. You'll likely end up owning a portfolio that's missing some companies as well.
 
At the same time, Aperio aims to keep the portfolio acting like the S&P 500 as much as possible by quantifying your preferences and objectives – be they environmental, social, religious, or virtually anything else. Subjectivity, in other words, is no longer an impediment to indexing.
 
"You can be as customised as you want in terms of wishes and still do your best to track an index," says Debra Wetherby, CEO of Wetherby Asset Management, a San Francisco wealth manager that uses Aperio's SRI indexing services on behalf of clients.
 
The process begins with a questionnaire outlined by a firm like KLD Research & Analytics or IW Financial, which rank companies on SRI issues. In turn, stocks in the index are scored based on your view of the world. With results in hand, Aperio runs your social agenda through its quantitative analytical system and rebuilds the index according to your specifications.
 
"The customisation process is a dialogue, where you're having a conversation of what criteria's important and how rigid you want to be about it" explains Dan Porter, founder of the Portland, Maine-based IW Financial, which advises Aperio on SRI screening.
 
Ideally, the end result is a customised index that behaves exactly as the target index while meeting your SRI standards. Alas, in the real world there's almost always a tradeoff of some degree. Depending on the SRI goals, you may have to bend a little.
 
Typically, investors give up some of their social objectives if they want to track a given index more closely. Alternatively, investors can retain higher degree of their SRI principles if they're willing to accept an index that moves a bit more independently of the target benchmark. Finding the right balance is now up to you.

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