1. Geczy’s Challenge to SRI Lloyd Kurtz Academic Challenges Session SRI in the Rockies

2. Levels of the Debate Academic Professional Rep/Client Relationship The Public

3. Three Arguments Against SRI It will impose diversification costs. –Proponents: Strict CAPM theorists. –Large literature fails to show this. Being motivated by anything other than profits will hurt results. –Proponents: Friedman, Posner. –Lousy logic (motivation ≠ results), large literature shows SRI returns are competitive. Screens will interfere with active management strategies. –Proponents: Geczy –Hardly any research in this area.

4. Geczy’s Main Point For skillful investors, constraints matter.

5. Geczy’s Message to Social Investors If you’re just trying to match market returns, you are probably ok. But just comparing mean returns doesn’t help investors seeking superior investment results. If you believe you are a skillful investor and seek superior return opportunities, the small SRI mutual fund universe limits your ability to profit from your skill.

6. Geczy’s Data Mutual Funds, not stocks –35 screened SIF list of screened funds + others 859 unscreened CRSP survivorship-free database 1963-2001 time period

7. Geczy’s Levels of Analysis Returns –Posterior Means / Attribution Analysis Optimization Using Three Models –CAPM –Fama & French –Four-Factor-Model Bayesian Skill Assumptions

8. Posterior Means / Attribution Average “alpha” using a risk attribution model is higher for the 35 screened funds than for the 859 average unscreened funds. Model adjusts for: –Beta –Price/Book Ratio –Market Cap –Momentum Benchmark: CRSP Total Stock Market

9. Mispricing: CAPM Returns are explained by the risk-free rate and beta. SRI optimal portfolio lags unscreened optimal portfolio by 4-6 bps per month. Difference largely explained by expense ratios. “Using three SRI funds, the market indexer can reasonably mimic [the Vanguard Total Stock Market Index.” Geczy: “This is a remarkable finding.”

10. Mispricing: Fama & French Same as CAPM, plus Price/Book ratio and market cap. Difference between SRI optimal and unscreened optimal portfolios is 31-34 bps per month. Geczy: “The SRI universe does not offer funds that come as close to offering the exposures to the size and value factors possessed by portfolios identified as optimal under the Fama- French model.”

11. Mispricing: Four-Factor-Model Same as Fama & French, plus momentum. Difference between SRI optimal and unscreened optimal portfolios is 31-34 bps per month.

12. Performance Disadvantage vs. Optimal Unscreened Portfolio (bp per month) Geczy: “It thus appears that priors on the prospect of manager skill are of first order importance, while mispricing uncertainty, at least for CAPM, is less important.” ModelNo SkillLots of Skill CAPM4-6 bps99-117 bps Fama/French31-34 bps150 bps Four-Factor36-37 bps149-152 bps

13. The Paradox of Skill Investors who believe they cannot identify skillful managers should index. Investors who believe they can identify skillful managers should pursue active management strategies. About ½ of investors who believe they can identify skillful managers will be proven wrong, and will subsidize the returns of the outperformers.

14. Critiquing Geczy This is just one study, and it certainly is not definitive. Geczy doesn’t show a cost in the usual sense (underperformance vs. a benchmark). Geczy’s cost is the difference between an optimal portolio and a screened optimal portfolio. The findings are applicable to anyone who limits their universe, not just social investors. And everyone limits their universe. The skill assumptions look aggressive, and Geczy is silent on the existence of skill. It’s very interesting from an academic perspective, but practical significance is debatable.

15. Some Key Takeaways Constraints matter to investors who believe they have skill. If you’re looking for Michael Jordan, you have a better chance of finding him if you look all over the country than if you just look in three Philadelphia schoolyards. This is not just an SRI effect, it is true of any constraint. The results of this study are so powerful, even dramatically changing the % of excluded funds (say from 3% to 20%) would have little effect on the final conclusions. Mean risk-adjusted returns are an incomplete way to measure the performance of SRI. It’s appropriate to use Fama & French and Carhart here. Geczy et al are silent on the existence of skill. Geczy et al are highly relevant to those who believe they have skill, and the relevance increases as your belief in your skill increases.