Private family foundations that want to express their mission values through socially responsible investing (SRI), often must choose from a universe of expensive, actively managed products with weak performance or index products with limited flexibility and no SRI proxy voting. The trade-off is weak performance for being socially responsible.

Aperio Group, an indexing outfit in Sausalito, California, purports to have a better approach. Aperio’s clients are predominantly high-net-worth families and foundations, each with a separate account starting at a minimum of $1 million. The firm creates customized SRI portfolios it says match each client’s personal values while delivering the diversification, risk reduction and low fees of indexing. “Clients get the best of both worlds: A portfolio that reflects what they believe in—and tracks their benchmark.”

 

No Investment Penalty for SRI

In a recent telephone interview, Aperio’s Chief of Staff Liz Michaels described the firm’s approach to creating SRI portfolios. This combines detailed evaluations of companies’ social responsibility with Aperio’s own financial models. “What most people don’t realize is that the cost, from a risk perspective, of screening a portfolio (positive, negative or best in class) is often negligible,” she said. “As a firm, we don’t believe there is alpha to be had through SRI, but we also don’t believe and can theoretically and empirically prove that there are no investment penalties for doing so.”

One SRI client Michaels cited as an example is a West Coast family whose private foundation makes significant allocations to issues around the environment. Members of the family’s younger generation, adult children, came to Aperio after examining the investment portfolio and realizing that it held some of the same companies the foundation was committed to oppose. They wanted market exposure, but the current portfolio did not make sense.

As with all its SRI clients, Aperio’s first stepwas to help the family articulate the foundation’s values. The process begins with a “social conversation” with the client to ascertain the foundation’s mission or the individual investor’s true values and beliefs—the things that are most important to them and those that aren’t.

Out of the conversation comes a values policy statement that can be translated into a quantitative overlay on an index of the client’s choosing—for example, the Russell 3000, S&P 500 or MSCI EAFE. Clients who want a completely customized portfolio (as opposed to a pre-assembled one, such as SRI or Green, to track their chosen benchmark) then decide which environmental, social or governance (ESG) screens they prefer.

Aperio has two ways to include ESGissues through screening. It can exclude companies with any ESG issues. Or it can rate companies, giving them scores of 1 (worst) to 100 (best) on how they stand according to specific ESG issues. Scoring can highlight the best companies, and those with the worst scores can be excluded, leaving in “best in breed.” Data to support these scores come from various sources, such as the Environmental Protection Agency and corporate libraries, and are accumulated on various commercial databases. Aperio uses a database provided by IW Financial.

The next step involves multiple portfolio optimizations to minimize tracking error (a measure of how closely a portfolio follows its benchmark index), optimize tax impact (for taxable clients) and maximize the custom social score (Aperio’s proprietary scoring system). “We’ll re-optimize the portfolio around these positive and negative exclusions, adhering to the extent possible to the factor weights that are in the index,” Michaels said. Then the client has to make a decision: for non-taxable clients, how much tracking error to accept.

Is there a performance penalty for aligning a stock portfolio with an investor’s values? Often a negligible one, according to Michaels. As an example, she said that adjusting a portfolio for only those companies with good environmental records results in an estimated tracking error on the index of 85 basis points. That translates into an incremental risk (standard deviation) of 2 basis points, which has an expected impact on returns of -1 basis point.

Michaels said that too often the idea of having a portfolio reflect values gets pooh-poohed by consultants and advisors associated with the family—and women (usually) and children who support this are patronized. “Part of arming people who want to do [SRI] with the numbers is: You can argue you don’t want to do this strategy, but you can’t argue that the math is wrong.”