Fiduciary Aspects of Social Investing

1. Fiduciary Aspects of Social Investing Lloyd Kurtz Sr. Portfolio Manager Nelson Capital Management Santa Clara County Estate Planning Council April 23, 2007

2. Topics • Background on Social Investing • Diversification • Performance • Evidence of Social Outperformance?

3. Background on Social Investing

4. 1980 1989 – DSI 400 1971 Key Moments in the History of SRI Socially responsible investing has a long history 19th Century: Religious investors avoid investing in alcohol, tobacco, gambling, weapons manufacturing, and other objectionable activities 1980s: Religious investors join forces with the Nuclear Freeze Movement and church groups in South Africa 1971: Pax World Fund founded, first socially screened mutual fund 1989: Launch of Domini Social Index, first broad-based social index

5. Money and Faith “In the New Testament, Jesus had more to say about money matters than any other single subject, be it worship, sexual behavior, violence and peace, or even eternal life...for those who would follow Jesus, economic questions are really spiritual questions.” - Burkholder (2002)

6. Social Investment Strategies • ‘Negative Screening’ • Excludes companies violating social screens • Positive Screening’ • Seeks to proactively include exemplary companies • ‘Shareholder Activism’ • Promotes change through negotiation and shareholder resolutions • Community Investing • Direct investment through micro-lending, social venture, and other mechanisms.

7. Socially Responsible Investing in the U.S. Socially Responsible Investing in the U.S. reached $2.3 trillion in 2005 Community Investing 1% $20 billion Screening + Shareholder Advocacy5% $117 billion Screening Only68% $1,568 billion ShareholderAdvocacy Only26%$586 billion Source: Social Investment Forum, SRI Trends Report 2005

8. Types of Social Investors Institutional investors in SRI include: Religious Organizations • Catholic • Methodist • Christian Science • Islamic Family Offices Non-profits (“Mission-Based Investing”)

9. Prevalence of Different Social Screens Mutual Fund Assets by Screen Types $ Billions Source: Social Investment Forum, SRI Trends Report 2005

10. Diversification

11. ERISA • “A fiduciary must diversify the plan investments so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.”

12. Uniform Prudent Investor Act of 1994 • “A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”

13. CFA Institute “Diversify. Members and candidates should diversify investments to reduce the risk of loss, unless diversification is not consistent with plan guidelines or is contrary to the account objectives.” - CFA Institute Standards of Practice Handbook, 2007

14. Two Areas of Apparent Latitude • No quantitative guidance as to how much diversification is enough. • Some provision in the language for exceptions based on the individual situation.

15. More Stocks Improve Diversification Firm-Specific Risk Market Risk

16. Comparison of Three Funds Sources: iShares website, March 2006, Zephyr performance system.

17. Theory Says: Own Everything In modern portfolio theory, the market portfolio (point P) offers the best combination of risk and return. This can be accessed via a low-cost index fund. The argument theorists make against social investing is the same they make against active portfolio management.

18. Performance

19. Sin Has its Rewards...

20. But Social Investors Have Done OK!

21. Past Ten Years Domini Social Index +8.3% S&P 500 +8.2% Overall Performance Annualized Returns • Slightly Higher beta • Modest growth bias • Sector weights • Overweighted in Technology, Consumer • Underweighted in Energy, Utilities Domini Return Differences Likely Due To: Source: KLD Website, as of March 31, 2007.

22. Complex Attribution Studies • Equities • Kempf and Osthoff (2006) • 1992-2004 • Small Positive SRI effect • Geczy (2003) • 1963-2006 • No SRI Effect • Bauer, Koedijk, and Otten (2002) • 1963-2001 • No SRI Effect • Fixed Income • Derwall and Koedijk (2006) • No SRI Effect These studies all use the Carhart model, which accounts for style, market capitalization, and momentum effects.

23. DS 400 Index, 5/90 – 12/06 Fama/French Regression of Monthly returns That is not supposed to be a positive number. Not statistically significant, however.

24. Past Three Years Domini Social Index + 8.0% S&P 500 +10.1% The Energy Problem Annualized Returns

25. Evidence of Social Outperformance?

26. Two Interesting Areas • Environment • Governance

27. Studies Showing an Environmental Effect • Guenster,Derwall, Bauer, and Koedijk (2005) • 1996-2002 time period • Shows stocks ranked highly by Innovest had higher valuation ratios and capital efficiency ratios. • Derwall, Bauer, and Koedijk (2005) • 1995-2003 time period. • Backtest shows highly-rated stocks outperformed lowly-rated ones. • Dowell, Hart, and Yeung (2000) • Favorable impact on price/book ratios • Cohen, Fenn, and Konar (1997) • Russo and Fouts (1997)

28. Is There a CalPERS Effect?

29. Constructing the CalPERS Focus List • Quantitative Screen • Stock Performance • Capital Efficiency • Corporate Governance • Qualitative Review • Overall financial performance • Valuation • Strategic plans • Management and board member relations • Compensation Practices • Other miscellaneous shareowner issues (including takeover defense) • Engagement Process – Since Exit is Impossible, Try Voice • “CalPERS considers the engagement process to be a crucial component of the overall Focus List Process. CalPERS makes a persistent effort to meet with the management and directors to discuss performance and governance issues. CalPERS will focus on reforming the company's governance practices with an emphasis on accountability, transparency, independence, and discipline.” Source: CalPERS

30. Short-Term Impact • Barber finds a “small, but reliably positive” +0.25% effect on announcement date. • “My best estimate, based on conservative short-term market reactions, indicates CalPERS activism has resulted in total wealth creation of $3.1 billion between 1992 and 2005.”

31. Long-Term Impact Source: Barber (2006)

32. Notes Barber, Brad. “Monitoring the Monitor: Evaluating CalPERS’ Shareholder Activism.” Working Paper, University of California, Davis, March 2006. Bauer, Rob, Kees Koedijk, and Roger Otten. "International Evidence on Ethical Mutual Fund Performance and Investment Style." Working Paper, January 2002. Burkholder, J.R. “Biblical Faith and Investment: Toward a Theology for ‘Making Money.’” Mennonite Mutual Aid, 2002. Accessed at: http://www.mmapraxis.com/features/columns/feature_burkholder.html Cohen, Mark, Scott A. Fenn, Shameek Konar. "Environmental and Financial Performance: Are They Related?" Working paper, May 1997. Derwall, Jeroen, and Kees Koedijk. "Socially Responsible Fixed-Income Funds." Working Paper, Erasmus University, May 2006. Derwall, Jeroen, Nadja Guenster, Rob Bauer, and Kees Koedijk. "The Eco-Efficiency Premium Puzzle." Financial Analysts Journal, March/April 2005. Dowell,  Glen, Stuart Hart, and Bernard Yeung. "Do Corporate Environmental Standards  Create or Destroy Market Value?" Management Science, August 2000. Geczy, Christopher C., Robert F. Stambaugh, and David Levin. "Investing in Socially Responsible Mutual Funds." Wharton School, Working Paper, May 2003. Guenster, Nadja, Jeroen Derwall, Rob Bauer, and Kees Koedijk. "The Economic Value of Corporate Eco-Efficiency." Working Paper, Erasmus University, July 25, 2005. Kempf, Alexander and Peer Osthoff. "The Effect of Socially Responsible Investing on Financial Performance." Working Paper, University of Cologne, Germany. June, 2006. Orlitzky, Marc, Frank L. Schmidt, and Sara L. Rynes. "Corporate social and financial performance: A meta-analysis." Organization Studies, 24, 2003. Russo, Michael V., and Paul A. Fouts. "A Resource-Based Perspective on Corporate Environmental Performance and Profitability." Academy of Management Journal, June 1997. Wesley, John. “The Uses of Money.” Edited by Jennette Descalzo, student at Northwest Nazarene College (Nampa, ID), with corrections by George Lyons for the Wesley Center for Applied Theology. General Board of Global Ministries, The United Methodist Church, 2000. Accessed at: http://gbgm-umc.org/umhistory/wesley/sermons/serm-050.stm