1 The Cost of Socially Responsible Investing* Mark Kritzman Windham Capital Management and MIT Sloan School *Research performed in collaboration with Timothy Adler

STATE STREET ASSOCIATES Outline Confusion Research objective and methodology Results Options Conclusion

STATE STREET ASSOCIATES Socially responsible investing versus active management  Investors who hold socially “good” companies because they expect them to outperform socially “neutral” or “bad” companies are not engaged in socially responsible investing; instead they are engaged in active management.  Langbein and Posner (1980) define socially responsible investing as “excluding the securities of otherwise attractive companies because the companies are judged to be socially irresponsible, and including the companies of otherwise unattractive companies because they are judged to be behaving in a socially laudable way.”  It follows from this definition that the exclusion of just one bad company which is expected to outperform its good company substitute imposes an expected cost, even if good companies, on average, are expected to outperform bad companies.

STATE STREET ASSOCIATES Socially responsible investing versus active management  You claim to invest in good companies to do good and because you expect good companies to outperform bad companies.  However, you identify a few good companies that you expect to underperform their bad company substitutes, even though on average you expect good companies to outperform bad ones.  If you choose the few good companies that you expect to underperform you are being socially responsible, but you incur a cost.  If you choose the few bad companies that you expect to outperform you are doing active management.  You can’t have it both ways. Thought experiment

STATE STREET ASSOCIATES Active versus passive management  Some claim that it is possible to construct a portfolio from a restricted list that closely matches the factor exposures of the target benchmark.  This claim may be true, but it is irrelevant to our argument.  We argue and demonstrate that skillful investors have less opportunity to add value from a restricted universe than they do from an unrestricted universe, irrespective of whether or not the factor exposures of the portfolio and benchmark match.  Our focus is on active management, not passive management

STATE STREET ASSOCIATES Logic versus play on words Syllogism Portfolios of stocks selected from restricted lists have lower performance. Socially responsible portfolios are selected from restricted lists of stocks. Therefore, socially responsible portfolios have lower performance Play on words No one is perfect I am no one Therefore, I am perfect

STATE STREET ASSOCIATES Research objective  Our primary research objective is to validate and to quantify the major premise - that there is a cost associated with restricting investment for skillful investors.  Secondarily, we show how this cost varies with five factors: Level of skill Degree of restriction Cross sectional dispersion of unrestricted opportunity set Number of securities selected for portfolio Market return  Because we use simulation, we avoid the sample bias of empirical studies.  Our framework easily allows others to modify our assumptions and even to incorporate views about the expected relative performance of good and bad companies.  We express no view as to whether or not one should divest.

STATE STREET ASSOCIATES Methodology 1.We rank the returns of an investment universe from highest to lowest. 2.We then introduce noise to the ranking by randomly selecting return pairs and switching their positions. The number of return pairs we switch is determined by the skill level we wish to simulate. 3.We select a sub-sample of securities, starting at the top of the list and working our way down the list, which represents the portfolio for an investor with imperfect foresight who selects from an unrestricted universe. 4.We randomly delete some fraction of the original universe to capture the effect of restricting the universe for purposes unrelated to expected performance. 5.We again select a sub-sample comprising the same number of securities starting at the top and working our way down the list. Because we have randomly deleted some of the original securities from the top of the list, we are forced to replace them with lower return securities. 6.We subtract the average of the security returns selected from the restricted universe from the average of the security returns selected from the unrestricted universe. This difference is the cost of socially responsible investing for an investor with imperfect foresight. 7.We repeat steps one through seven 10,000 times and compute the average cost.

STATE STREET ASSOCIATES Hit rate, information coefficient, and information ratio

STATE STREET ASSOCIATES The cost of socially responsible investing (100 stock portfolio)

STATE STREET ASSOCIATES The cost of socially responsible investing (250 stock portfolio)

STATE STREET ASSOCIATES Multi-year cost ($1 billion portfolio, 8% market return)

STATE STREET ASSOCIATES Option 1: Restrict universe And hope that by doing so you will:  Raise a bad company’s cost of capital, and thereby persuade it to reform.  Draw attention to a bad company’s bad behavior, thereby influencing consumers to avoid its products and services, which in turn, may persuade the company to reform.  Draw attention to a bad company’s bad behavior, and by moral suasion, persuade it to reform.

STATE STREET ASSOCIATES Option 2: Do not restrict universe And:  Save 5,000 years of tuition, assuming a cumulative cost of $270 million and annual tuition of $50,000.  Save 2,000 years of faculty salary, assuming a cumulative cost of $270 million and a salary of $150,000.  Deploy $270 million directly toward improving the carbon footprint of the university.

STATE STREET ASSOCIATES Option 3: Do not restrict universe And deploy savings directly toward:  Discovery of new energy alternatives.  Policies designed to curb consumption of fossil fuels.  Shareholder activism to influence company behavior.

STATE STREET ASSOCIATES Conclusion  We do not argue for or against any of these options.  Instead, we argue that investors should measure whether it is more effective to: restrict investment and incur a cost with the hope of influencing behavior, or invest without restriction and deploy the savings directly toward some combination of the institution’s mission and social improvement.