Alternative Indices

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While market capitalization weighted indexes are quite common, there are other types of indexes. Social Responsibility Indexes retain market capitalization weighting methodologies, but apply ethics based screens for security selection. Inverse and Leveraged Indexes employ derivatives or leverage to a capitalization weighted stock index. Fundamental Indexes and Dividend Weighted Indexes weigh their respective indexes according to valuation and dividend weights. As the name implies, an Equal Weighted Index weighs its securities with equal, not market capitalization, weightings.

Contents

Social Responsibility Indexes

Socially Responsible Investing (SRI) is a style of investing that chooses investments that seek to encourage corporations to improve their practices on environmental, social, and governance issues. [1]. According to the Social Investment Forum’s 2007 Report on Socially Responsible Investing Trends, SRI held $2.71 trillion in total assets under management out of the $25.1 trillion in the U.S. investment marketplace. The report identifies 173 SRI mutual funds and 8 SRI exchange traded funds. [2]

SRI adopts the following investment approaches to security selection and fund management:

  • Screening : Screens can be both positive and negative. Positive screens seek companies judged to have good employer-employee relations, strong environmental practices, products that are safe and useful, and operations that respect human rights around the world. SRI funds tend to negatively screen companies whose products and business practices are judged harmful to individuals, communities, or the environment.
  • Shareholder advocacy: involves SRI funds taking an active role as shareholders. This includes talking with companies on issues of social, environmental or governance concerns as well as filing shareholder resolutions on such topics as corporate governance, climate change, political contributions, gender/racial discrimination, pollution, and problem labor practices.
  • Community Investing :directs capital from investors and lenders to communities that are judged underserved by traditional financial services institutions. Community investing provides access to credit, equity, capital, and basic banking products that these communities might otherwise lack. [3]

Each SRI index provider tends to have differing detailed social and ethical criteria for screening companies, so an investor needs to assess each index (and SRI fund) to assure that the ethical standards of the investment match his or her ethical convictions. Among the industries commonly excluded from SRI indexes are tobacco, alcohol, adult entertainment, firearms, gambling, nuclear power, and military weapons. [4] SRI indexes have been developed based on environmental criteria (Sustainability Indexes)[5] and on religious criteria (Catholic and Islamic Indexes.)

The oldest SRI Index is the Domini 400 Social Index, which started in 1990. The Calvert Social Index started in 2000, and the FTSE4Good Indexes date from 2005. Currently index funds and ETFs are available that track the Domini 400 Social Index, the FTSE4Good Select Index, and the KLD Broad Market and KLD Select Social Indexes. [6] KLD has created a series of social indexes which cover the entire US market and discrete segments of the market:


KLD Social Responsibility Indexes


Performance

The performance history of SRI Indexes is short. Statman (2005) found that during the period May 1990 – April 2004 the Domini Social 400 Index produced a monthly alpha that exceeded that of the S&P 500 Index by 0.09%. However, none of the alphas are statistically significant. The correlations between the returns of socially responsible indexes and the S&P 500 Index were high but tracking errors were substantial. For example, the mean difference between the returns of the DS 400 Index and the S&P 500 Index in 12-month periods was 2.49% and the maximum difference was 8.01%. Statman also found that the outperformance of SRI indexes above the S&P Index were period dependent, with outperformance coming in the 1990's and underperformance occurring with the market decline in 2000 and continuing through 2004. [7]. Ter Horst, Zhang, and Renneboog (2007) examined the global universe of SRI funds and found that from 1991-2003 US and UK SRI funds provided risk adjusted returns that tracked their indexes closely, while European and Asia Pacific SRI funds had risk adjusted returns that trailed their indexes by -5.00% annually. They also found that SRI fund returns were increasingly being explained by the Fama and French Three-Factor Model. [8]

Social Responsibility Index Methodologies

Academic Papers

  • Ceu Cortez , Maria, Silva, Florinda and Areal, Nelson, Socially Responsible Investing in the Global Market: The Performance of US and European Funds (February 13, 2009). Available at SSRN: http://ssrn.com/abstract=1342469
  • Geczy, Christopher Charles, Stambaugh, Robert F. and Levin, David, Investing in Socially Responsible Mutual Funds (October 2005). Available at SSRN: http://ssrn.com/abstract=416380 or DOI: 10.2139/ssrn.416380
  • Statman, Meir, Socially Responsible Indexes: Composition and Performance (January 2005). Available at SSRN: http://ssrn.com/abstract=705344
  • Ter Horst, Jenke R., Zhang, Chendi and Renneboog, Luc, The Price of Ethics: Evidence from Socially Responsible Mutual Funds (May 2007). ECGI - Finance Working Paper No. 168/2007; TILEC Discussion Paper No. 2007-012; CentER Discussion Paper Series No. 2007-29. Available at SSRN: http://ssrn.com/abstract=985265

Fundamental Indexes

Fundamental Indexing Weighting Factors [9]
  • Sales = company sales averaged over the prior five years.
  • Cash Flow = company cash flow averaged over the prior five years, defined as Operating Income plus Depreciation.
  • Book Value = company book value at the review date.
  • Dividend = total dividend distributions averaged over the last five years, including both special and regular dividends paid in cash.


[10]

RAFI Indexes are available from Charles Schwab (mutual funds} and Powershares ( as ETFs).

Fundamental Index Methodologies

Academic Papers

Equal Weighted Indexes

Equal Weight Index Methodology

Dividend Weighted Indexes

Dividend Weighted Index Methodologies

Inverse and Leveraged Indexes

Inverse and Leveraged Index Methodologies

See also

References

  1. ↑ Social Investment Forum Socially Responsible Investing Facts
  2. ↑ 2007 Report on Socially Responsible Investing Trends
  3. ↑ Social Investment Forum Socially Responsible Investing Facts
  4. ↑ Richard A. Ferri, All About Index Funds, ISBN 0-07-148492-2
  5. ↑ Dow Jones Sustainability Indexes
  6. ↑ SRI Index Funds:
  7. ↑ Statman, Meir, Socially Responsible Indexes: Composition and Performance (January 2005)
  8. ↑ Ter Horst, Jenke R., Zhang, Chendi and Renneboog, Luc, The Price of Ethics: Evidence from Socially Responsible Mutual Funds (May 2007). ECGI - Finance Working Paper No. 168/2007; TILEC Discussion Paper No. 2007-012; CentER Discussion Paper Series No. 2007-29
  9. ↑ FTSE RAFI Index Series Methodology Overview
  10. ↑ William Bernstein, Fundamental Indexing and the Three-Factor Model, Efficient Frontier, May, 2006

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