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CSRlive Commentary

07.14.2011 - 06:05PM

Category: Socially Responsible Investing

CSRwire Member Spotlight: Black Swans and Fat Tails

George-gay

On the eve of the annual SRI in the Rockies event George Gay, Chief Executive Officer of First Affirmative Financial Network, shares some insights based on 25 years of experience in socially responsible investing.

By CSRwire Contributing Writer Jayne Flannery

George Gay is fond of analogies. On the eve of the forthcoming SRI in the Rockies event, he explains his choice of a presentation entitled Black Swans and Fat Tails. "Historically people did not believe black swans existed and even when their existence was proven, they were still very rare. What we have learned after witnessing two 40 per cent drops in the US Stock Market over a single ten-year period is that much current thinking on how markets perform is out of date. Statistically, each of these events should occur less often than once in a century and the message must be that extreme events, particularly negative extreme events, are far more common than previously thought and that the risk inherent in the markets is far higher than the statistical premise that a lot of forecasting is based on."

However, he is convinced that investors who wish to forsake violence, pollution and social inequality do not need to forsake value. What is required though is an expert and highly structured approach to SRI if the fats tails of those black swans are to be plucked. The key challenge he perceives is in establishing measurement tools and benchmarks for the evaluation of SRI portfolio performance. Monitoring tracking error, also called active risk, is a tool routinely employed by First Affirmative Financial Network.

"It is a measure of the deviation from the benchmark," he explains. "An index fund would have a tracking error close to zero, while an actively managed portfolio would normally have a higher tracking error. Dividing portfolio active return by portfolio tracking error gives the information ratio, which is a risk adjusted performance metric."

"What we see is that SRI portfolios tend to outperform in rising markets and under-perform the S&P 500 during bear markets. This in part is because SRI has higher exposure to sectors such as health care, technology & financials which respond disproportionately to changes in consumer spending and lower exposure to industrials and commodities. Analysis on a 36 month rolling basis shows that over long periods SRI indexes rise higher in good times and have relatively softer falls than the overall market, but timing is crucial. Different starting points will give entirely different measurements."

Whilst he adheres to contemporary portfolio management theory in relation to the value of blending funds to end up with lower volatility and higher performance, he questions the qualitative criteria used by managers to narrow stock selection. "Any process that starts with 9,000 possible variables and then narrows those down to around 50 is in effect random selection from a statistical point of view and that ESG factors are an equally valid rationale to reducing the universe as any other."

"It is possible to get good performance for socially screened products, but we have to ask why shouldn't we believe ESG factors are a valid reason to evaluate a business? In translating social concerns into sound investment decisions, there is a need for much more than personal feeling over a particular issue if the values investors hold are to be used to create value."

"Moreover, if we look at all 70 SRI funds with a demonstrable 3 year track record, we see an almost random distribution (just as we would see looking at all conventional mutual funds) with some funds exhibiting superior performance and some inferior. Cherry-picking the best performers is not an option as it will inevitably mean supporting a narrow niche in the SRI universe with no guarantees at all that yesterday's performers will star in the future. That is why expert investment advice is crucial," he adds.

About First Affirmative Financial Network

First Affirmative Financial Network, LLC, is an independent investment advisory firm (SEC # 801-56587), specializing in socially responsible, sustainable and transformative investing. Since 1998, the company has managed investment portfolios for socially conscious investors who wish to direct investment capital to some of the world's most pressing environmental and social challenges.

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