Many asset owners who engage in values-aligned investing eschew the broad equity market – the S&P 500 or Russell 3000 – in favor of building an investment portfolio using criteria that reflect their views. In my work leading values-aligned research at Aperio, I help clients develop values policy documents to serve as road maps for values- aligned portfolios. I also monitor developments in the ESG research industry to understand what data is available to use in client portfolios.
Recently, in working with clients, we have noticed that over time some of their values- based portfolios have looked increasingly similar to the index. Why is that? Having been in the values-alignment industry for over 30 years, I believe the answer is that the broad equity market has moved toward views held by certain values-aligned investors. In a recent example, we have data to demonstrate this dynamic.
The Corporate Equality Index from the Human Rights Campaign (HRC) is one example of S&P 500 companies receiving higher scores in recent years. Launched in 2002, it evaluates companies on their policies, practices, and benefits for LGBTQ employees.
The index rates companies on a scale of 1 to 100, where 100 represents a perfect score. Aperio uses HRC data to help pro-LGBTQ clients align their investments with these views.
In 2018, 161 S&P 500 companies scored 100 — “perfect,” according to the HRC rating. (See the figure below for the number of S&P 500 companies with perfect scores each year.) Aperio established a standard approach to incorporate this data and deliver a low-tracking error portfolio that overweighted higher-scoring companies and underweighted lower-scoring companies (a tilt relative to a benchmark index) based on the CEI data. (Aperio uses a multi-factor optimizer to achieve the dual objectives of minimizing tracking error and achieving a higher weighted average values score.) This approach allowed us to create portfolios in which a portfolio’s target weighted average pro-LGBTQ score was 20% higher than the weighted average pro-LGBTQ score of the benchmark.
By 2021, the number of companies in the S&P 500 which scored 100 had risen to 236. This significant increase in perfect-scoring companies meant that the broad market was closer to the values expressed in the HRC rating. Because the weighted average benchmark score was higher with so many companies scoring 100, it was harder to construct a portfolio with a score 20% better than the benchmark score. To achieve a tracking error similar to the previous year, we had to lower our standard tilt level to +15%. This new standard tilt level still expresses higher values-alignment than the benchmark for clients selecting Aperio’s pro-LGBTQ option.
If more companies continue to adopt policies consistent with HRC values, ever more companies will receive “perfect” scores, giving the benchmark/market a higher weighted average score, and likely requiring additional lowering of the Aperio’s tilt level. For an investor interested in aligning their portfolio with this set of values, this isn’t necessarily a bad thing – rather, it indicates that more companies in the broad market benchmark are aligned with the issues about which she cares.
But this story isn’t over. When HRC released its data in late 2023, it had modified the ratings criteria — “raising the bar” as HRC put it — so that it was harder for companies to get a “perfect” score. It is worth emphasizing that for the portfolios we created using the HRC index, Aperio clients implicitly selected an option that accepted the HRC view of the world — and the evolution of that view over time. By modifying its ratings criteria, HRC indicated that it expects even more from companies on LGBTQ issues, and a portfolio adopting HRC-based criteria inherently expect more from them as well.
Using this data for Aperio clients in 2024, only 166 S&P 500 companies scored 100. When rebalancing portfolios using this new data to the standard +15% tilt level, we observed lower tracking errors, an indication of the ease with which the optimizer did its job. (In order to avoid a yo-yo effect, Aperio did not adjust the standard tilt level back to +20%. However, we consider tilt levels, tracking error, and other tradeoffs annually as part of our standard data update process, so we could see a return to higher tilt levels in future years.)
Figure: Count of HRC “Perfect” Companies in the S&P 500
Count is of S&P 500 companies as of the date indicated that scored perfect 100s in the most recently published annual Corporate Equality Index. Methodology for the rating changed with the November 2023 publication, reflected here in the June 2024 number.
In sum, over time, the impossibility of achieving the same portfolio tilt relative to the benchmark may not be an indicator that a values-aligned portfolio was misconstructed but rather show that the benchmark index is reflecting broader corporate uptake of practices consistent with a particular client’s values and criteria than previously observed. Asset owners may want to discuss these dynamics with their managers.
Ultimately, greater similarity between a values-aligned portfolio and index presents an opportunity for investors to consider whether their current criteria best reflect their values and mission or whether additional criteria may be appropriate. Investors that use their portfolio criteria to signal a desire for societal change have a particular opportunity in these situations to follow up on changes they already see on issues about which they care.
Thank you to Simge Ulucam, Kirsten Meder, Liz Michaels, Lisa Goldberg, and Michelle Friedman for their help on this article.
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