INVESTMENT & ECONOMIC ANALYSIS: March 2000
SOCIAL TOPICS (Archive): INVESTMENT & ECONOMIC ANALYSIS
Asset Allocation for Social Investors:
New ways to ask the old questions
Published, March 2000
For years social investors battled the perception that there was a trade-off between achieving social objectives and investment return. This meant that the energies of social investment professionals were focused on overcoming the “biases” of social investing, in order to make social portfolios behave more like unscreened ones. The time has come to move the discussion forward, to address the trade-off between risk and potential reward faced by all investors. And to find a place for social objectives within that traditional framework for efficient asset allocation.
Nobel laureate economist Harry Markowitz put forward the idea that combining somewhat uncorrelated assets such as stocks, bonds and real estate in a portfolio allows investors to earn similar returns with less volatility than investing in any one asset by itself. Many investment professionals consider asset allocation to be the most important decision you can make. Combinations of asset classes are frequently arrayed graphically in a continuum of rising potential reward and risk called the “efficient frontier,” along which each investor can choose the optimal risk/return trade-off and asset allocation mix. The more risk one assumes, the greater the potential financial reward. Conversely, the lower the target return one seeks, the less the potential risk.
Would these conclusions/recommendations be equally true for social investors' portfolios? (This is like asking: can the findings from heart disease studies done on males be extrapolated to females?!)
Social Portfolios on the Efficient Frontier
We expect to find that screened social portfolios can lie along the efficient frontier, but may be composed differently from those that are not screened, in terms of the optimal asset mix. After 25 years of managing social and unscreened portfolios, we know a lot about the building blocks for a diversified asset mix: U.S. equity and bond portfolios, international equities, small cap stocks, to name but a few. The question now is: How do these component parts combine to produce an efficient portfolio? (For those mathematically inclined, what do the covariances look like?)
We know, for example, that the half of S&P500 companies that pass our typical Walden comprehensive social screens have a small cap bias, lower international exposure, more growth, and lower dividends, relative to the S&P500. We have learned to rebalance portfolios to compensate for most, but not all of these biases. (Our inaugural edition of Values in 1992 presented the results of our research on this issue.) Nonetheless, certain differences persist. For instance, we would expect ex ante that an asset mix on the efficient frontier would select more international and less small cap investments as complements to a social large cap portfolio.
We also must consider whether the efficient portfolio makes different choices in the stock/bond mix. Social screens are potentially more restrictive in the fixed income area: Many exclude Treasuries, a significant and liquid portion of the Lehman Government Corporate Bond Index. Many industrial corporate bonds are ruled out too. To the extent social bonds behave differently as an asset class, their covariance with stocks, especially social stocks would affect asset allocation.
While any remaining differences in portfolio characteristics are likely to result in short-term differences in performance, we believe that a properly constructed social portfolio can provide an equally efficient balance of risk and reward.
The Socially Efficient Frontier?
Different combinations of various types of assets may be equally efficient in that they offer the same potential return for a given level of expected risk. Yet some of these combinations may work better to meet an investor’s social goals. These goals may determine the preferred portfolio mix — whether stocks and bonds suffice, or should be supplemented with investments in community development funds and a portfolio of innovative “solutions” companies.
This set of trade-offs is unique to social investors. There is little in the conventional asset allocation literature to guide us. A social investor may have a dedicated allocation to community development investments, which are relatively short-term, but illiquid. Traditional asset allocation models treat short-term investments as a residual of manager strategy to provide liquidity for achieving investment goals. At the other end of the risk/reward spectrum, a social investor may make mission consistent venture or socially positive small cap investments in order to direct capital to solutions companies. We continue to examine the implications of these social asset choices on the mix of remaining assets to be allocated.
These are the challenging new questions about the complex intersection between risk, reward and social goals that today’s sophisticated multi-asset portfolios call for. We’re excited to be building these new frameworks.
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