Due to the increasing importance of SRI in the European institutional and retail markets, sustainable indices are becoming an important tool for assessing SRI performance, and more and more sustainable indices are being launched. In this article, we would like to evaluate the performance and relative risk of the most prominent sustainable indices, and above all to answer the following questions:
o Do sustainable indices under-perform or out-perform, compared with traditional indices?
o Are performance differences due purely to a “sustainable alpha-effect” or are more traditional, financial parameters responsible for these differences?

Comparisons of risk and performance between sustainable and
traditional benchmarks
Long-term comparisons between sustainable indices and traditional benchmarks should be taken with a pinch of salt. The problem is that most sustainable selections have not existed that long, so their history needs to be extrapolated. Comparing a historical simulation of a sustainable index with the real return and risk of a traditional index is not entirely correct, since the sustainable index has been put together at a much later point in time and tends as a result to be over-weighted in equities which have risen substantially over the entire observation period, while equities that have under-performed occur much less frequently. In order to keep this statistical error as low as possible, we adhere to a short evaluation horizon and limit the back tracking period to a maximum two years.
From table 1 it can be seen that during the observation period all sustainable indices out-performed the traditional reference indices. At the same time the total risk was higher. In order to make a correct comparison, therefore, we have to do this on the basis of risk-corrected performance benchmarks. Even after correction for the higher risk, the sustainable indices appear to have out-performed the traditional reference indices.
The next question is whether the out-performance that has been found is statistically significant, ie, great enough in terms of the continual variations in performance to be sure it is not a result simply obtained by chance. This can be verified by the information ratio (see Table 2), which compares the out-performance of a sustainable index with its tracking error. The tracking error is a yardstick by which to measure the performance variations between two portfolios, in this case the sustainable index and the traditional reference index. Analysis of the excess performance indicates that for all benchmarks studied, the observed out-performance is of no statistical significance or, in other words, remains within a margin of variations that occur by chance (see the t-test column).
Similarly one can also ask whether the higher volatility that we have found in the case of most sustainable indices
deviates enough to be able to say that we are dealing with a higher risk level. This, too, can be seen from the table (see the F-test column). One can conclude that the volatility of sustainable indices is not significantly higher than the volatility of traditional indices. The only exception is the Ethibel Europe index.
From table 2 it can also be seen that tracking errors vary from around 3% (ASPI) to 7% (Ethibel). This shows that sustainable investment strategies are delivering returns that, certainly in the short and medium term, can deviate from traditional strategies, both up and down. Below we will look at the source of that tracking error or, in other words, at what causes the differences in the financial characteristics of sustainable and traditional indices.

Multi-factor regression
Most sustainable indices show some style biases. From an analysis of market sensitivity, it appears that most sustainable indices have a beta greater than one. This provides an initial explanation for the higher return and the higher risk that we have observed above.
These differences in style factors can give a distorted picture when we compare the performance of sustainable indices with that of their conventional counterparts. By extending the CAPM model with size and value factors according to the Fama and French methodology, we can extract the alpha or “style-corrected out-performance” of the indices. This is the residual out-performance, after correcting for the portfolio’s possible style biases.
The results of this analysis are shown in Table 3. Sustainable universes are apparently over-weighted in large cap stocks (with the exception of the Domini Social index.) One possible explanation is the fact that large cap companies have the resources to appoint a dedicated sustainable development officer and to set up a specific SRI communication strategy. Only the Ethibel World index and the Domini index appear to have a growth bias, which seems to be correlated to an over-weighting of TMT stocks.
After correction for style biases, the residual returns or alpha’s are positive for all of the sustainable indices.

Conclusion
From the above figures we can conclude that sustainable and traditional indices historically performed broadly in line. Return and risk characteristics are slightly in favour of sustainable indices, but performance differences are, except in one case, not statistically significant. This is great news for investors who want to integrate environmental, social and ethical principles in their investment policy.
The tracking error differs substantially from one sustainable index to another. This is due to the severity of sustainable screening. Active sustainable investment funds can substantially drive back the tracking error by neutralising the sector and country deviations and by bringing the style factors into line with the traditional index. Establishing a disciplined sustainable investment process is therefore the most important challenge that a responsible sustainable asset manager faces (see page 20).
Filip Corten is Senior Asset Manager, Sustainable Management at Dexia Asset Management

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