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Geczy’s Challenge to SRI

Geczy’s Challenge to SRI. Lloyd Kurtz Academic Challenges Session SRI in the Rockies. Levels of the Debate. Academic Professional Rep/Client Relationship The Public. Three Arguments Against SRI. It will impose diversification costs. Proponents: Strict CAPM theorists.

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Geczy’s Challenge to SRI

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  1. Geczy’s Challenge to SRI Lloyd Kurtz Academic Challenges Session SRI in the Rockies

  2. Levels of the Debate • Academic • Professional • Rep/Client Relationship • The Public

  3. Three Arguments Against SRI • It will impose diversification costs. • Proponents: Strict CAPM theorists. • Large literature fails to show this. • Being motivated by anything other than profits will hurt results. • Proponents: Friedman, Posner. • Lousy logic (motivation ≠ results), large literature shows SRI returns are competitive. • Screens will interfere with active management strategies. • Proponents: Geczy • Hardly any research in this area.

  4. Geczy’s Main Point For skillful investors, constraints matter.

  5. Geczy’s Message to Social Investors • If you’re just trying to match market returns, you are probably ok. • But just comparing mean returns doesn’t help investors seeking superior investment results. • If you believe you are a skillful investor and seek superior return opportunities, the small SRI mutual fund universe limits your ability to profit from your skill.

  6. Geczy’s Data • Mutual Funds, not stocks • 35 screened • SIF list of screened funds + others 859 unscreened • CRSP survivorship-free database • 1963-2001 time period

  7. Geczy’s Levels of Analysis • Returns • Posterior Means / Attribution Analysis • Optimization Using Three Models • CAPM • Fama & French • Four-Factor-Model • Bayesian Skill Assumptions

  8. Posterior Means / Attribution • Average “alpha” using a risk attribution model is higher for the 35 screened funds than for the 859 average unscreened funds. • Model adjusts for: • Beta • Price/Book Ratio • Market Cap • Momentum • Benchmark: CRSP Total Stock Market

  9. Mispricing: CAPM • Returns are explained by the risk-free rate and beta. • SRI optimal portfolio lags unscreened optimal portfolio by 4-6 bps per month. • Difference largely explained by expense ratios. • “Using three SRI funds, the market indexer can reasonably mimic [the Vanguard Total Stock Market Index.” • Geczy: “This is a remarkable finding.”

  10. Mispricing: Fama & French • Same as CAPM, plus Price/Book ratio and market cap. • Difference between SRI optimal and unscreened optimal portfolios is 31-34 bps per month. • Geczy: “The SRI universe does not offer funds that come as close to offering the exposures to the size and value factors possessed by portfolios identified as optimal under the Fama-French model.”

  11. Mispricing: Four-Factor-Model • Same as Fama & French, plus momentum. • Difference between SRI optimal and unscreened optimal portfolios is 31-34 bps per month.

  12. Performance Disadvantage vs. Optimal Unscreened Portfolio (bp per month) Geczy: “It thus appears that priors on the prospect of manager skill are of first order importance, while mispricing uncertainty, at least for CAPM, is less important.”

  13. The Paradox of Skill • Investors who believe they cannot identify skillful managers should index. • Investors who believe they can identify skillful managers should pursue active management strategies. • About ½ of investors who believe they can identify skillful managers will be proven wrong, and will subsidize the returns of the outperformers.

  14. Critiquing Geczy • This is just one study, and it certainly is not definitive. • Geczy doesn’t show a cost in the usual sense (underperformance vs. a benchmark). Geczy’s cost is the difference between an optimal portolio and a screened optimal portfolio. • The findings are applicable to anyone who limits their universe, not just social investors. And everyone limits their universe. • The skill assumptions look aggressive, and Geczy is silent on the existence of skill. • It’s very interesting from an academic perspective, but practical significance is debatable.

  15. Some Key Takeaways • Constraints matter to investors who believe they have skill. • If you’re looking for Michael Jordan, you have a better chance of finding him if you look all over the country than if you just look in three Philadelphia schoolyards. • This is not just an SRI effect, it is true of any constraint. • The results of this study are so powerful, even dramatically changing the % of excluded funds (say from 3% to 20%) would have little effect on the final conclusions. • Mean risk-adjusted returns are an incomplete way to measure the performance of SRI. • It’s appropriate to use Fama & French and Carhart here. • Geczy et al are silent on the existence of skill. • Geczy et al are highly relevant to those who believe they have skill, and the relevance increases as your belief in your skill increases.

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