Replicating Indexes In R (Part III): Socially Responsible Investing

In previous installments of replicating indexes I profiled the style-analysis methodology and presented an example using a hedge fund index. Now let’s turn to a strategy of replicating the S&P 500 Index with a handful of stocks that are considered socially responsible investments (SRI).

What’s the rationale? A growing number of investors require that their equity portfolios match certain ethical and/or moral standards. Marrying SRI standards with money management can be challenging, however, in part because earning a reasonable return doesn’t always align with pursuing a social good, at least not perfectly. One way to bridge the gap is by selecting a group of investments that pass muster for a particular set of SRI criteria and then optimizing the weights of those investments so that they match the risk and return profile of an acceptable market index. The goal, in short, is investing with your SRI standards intact while tracking a benchmark with favorable financial attributes — the best of both worlds for an SRI investor.

As an example, let’s imagine an investor who wants to own the S&P 500 Index via SPDR S&P 500 ETF (SPY). But some of the constituent companies run afoul of her SRI standards. The solution: integrate the SRI criteria with SPY’s risk/return profile by fusing the two into one strategy via statistical decomposition using style analysis.

The first step is defining the SRI portfolio. There are several databases that screen companies. You could also come up with your own filter. For this test, let’s use ten stocks recently cited by the Hiring Success Journal. In July, the site published a list of 20 companies “demonstrating a diverse range of social responsibility goals and initiatives.” Ten of the firms are publicly traded stocks, including General Electric, IBM, Starbucks, and Apple. We can, of course, use any list we find appropriate, but for now, let’s stick with this set.