Wealth Manager

An intriguing example comes from a custom indexing
shop in the San Francisco area, a region that’s no stranger
to finding inspiration in the finance literature for minting
investment strategies. The Bay Area in the 1970s was host
to the original index fund and the first disciplined use of
tactical asset allocation in a quantitative framework. The
same spirit of academically motivated innovation is alive
and kicking at the Sausalito, Calif.-based Aperio Group
LLC. This nine-year-old boutique has updated portfolio
optimization for a new generation of tax-efficient and socially
responsible investing (SRI) indexing strategies.

Aperio’s forte is marrying the lessons of Markowitz with
client SRI preferences, while keeping an eye on tax gain/
loss-harvesting opportunities, and wrapping it all in an
indexing structure. The customers—mainly institutional
investors and wealth managers with high-net-worth clients—
tap Aperio’s services via separate accounts.

At first glance, Aperio’s money management may look
routine. The shop’s staples—custom indexing, SRI and tax
harvesting strategies—are fairly common as independent
services. But the blending of all three is still the exception
in money management.

Aperio—Latin for “reveal” or “uncover”—specializes in
quantitatively modeling investor preferences and incorporating
those preferences in strategies that track an index of
the client’s choosing. The result: An index portfolio that
hugs, say, the S&P 500 or MSCI EAFE while capturing a
client’s SRI values.

The strategy is one of modifying the classic optimization
formula, a cornerstone of modern portfolio theory (MPT).
In his 1952 paper, Markowitz outlined a quantitative technique
for building portfolios with the highest return at
the lowest risk (standard deviation). Aperio revises the idea
by analyzing SRI values that are specific to the investor in
relation to the target benchmark’s tracking error. The goal:
Building portfolios at the highest SRI values with minimal
divergence from the benchmark’s risk/return profile.

A related Aperio strategy is maximizing tax efficiency,
which is applied to all client portfolios in the process of replicating
benchmarks. The fee for its tax-savvy indexing starts at
35 basis points for domestic portfolios (40 basis points for international
mandates). Adding the optional SRI overlay runs
an extra 10 basis points. The combined services can be summarized
as a tax-managed, customized SRI indexing package.
Aperio’s portfolio engineering is innovative because it
merges two investing disciplines that are not naturally
complementary—MPT and SRI. Indeed, MPT is quantitative
by design and reliant on dense theory; SRI is inherently
subjective with no hard and fast rules.

Financial intuition suggests that building a portfolio
that aspires to a higher good requires giving up some aspect
of the market beta that’s otherwise available to investors who
are indifferent to SRI. But if a tradeoff is manifest, the cost can
and does vary—perhaps widely—depending on the strategy,
manager skills and investor goals.

Aperio claims that its proprietary strategies give investors
more bang for their SRI buck. The underlying process “is anchored
and grounded” in Markowitz’s portfolio optimization,
says Patrick Geddes, Aperio’s co-founder and chief investment
officer. Indexing and SRI are old news separately, but combining
the two is still unusual, he reports. One reason is that MPT
and SRI have typically existed in two distinct and largely disconnected
financial worlds. But that’s changing, as firms like
Aperio start to bridge the gap.

The quant perspective comes naturally to Geddes, who was
Morningstar’s director of quantitative research and later CFO
of the Chicago data firm before he co-founded Aperio in 1999.
He’s also on the finance faculty of the University of California
Berkeley Extension, where he sometimes lectures MBA students
on the finer points of investment theory.

Geddes’ more ambitious ideas are reserved for Aperio, which
excels in turning investors’ SRI preferences into hard numbers.
That’s easier said than done, given the vagaries of defining “socially
responsible” finance. “We’re approaching a wide range of
clients around some very different values,” Geddes says. “We’ve
got a Christian Science foundation for which we manage money,
for example, and their hot-button issues sure look different from
a traditional San Francisco Bay Area green-oriented liberal.”

From the environment to religion, from corporate governance
to peace advocacy and beyond, SRI’s rainbow of goals
and boundaries far outweigh its common elements. Socially
responsible is a tidy label, but it reveals almost nothing about
any one investor’s objectives other than suggesting that
there’s an agenda beyond simply turning a profit. That hasn’t
stopped the launch of SRI funds for the masses, including
specialty index funds. But publicly traded SRI portfolios can,
at best, only satisfy the average SRI investor by delivering
some generalized perception of social responsibility. That’s
sufficient for some investors, although wealthy clients and
institutions often strive for more precision. And for good reason,
since SRI is ultimately a personal decision, which means
that it’s ideally pursued as a customized strategy.

Meanwhile, investors who toe the MPT line should wonder
if off-the-shelf SRI portfolios and benchmarks are suboptimal
as per Markowitz, advises Geddes. It’s easy to select a group of
securities that hold fast to socially responsible ideals; it’s something
else to satisfy a particular investor’s SRI philosophy without
violating MPT tenets. According to Geddes, the challenges
that can harass publicly traded, one-size-fits-all SRI indices are:

* a large tracking error relative to the overall stock market
or targeted benchmark
* suboptimal portfolios á la Markowitz
* investor SRI preferences that aren’t maximized

Aperio claims to resolve all three, at least as far as anyone
can, and in a tax-savvy wrapper to boot. “That’s what’s so
appealing about the way we’re approaching [SRI indexing],”
Geddes asserts.

An added bonus is the enhanced transparency that flows
from quantitatively profiling the opportunities—and limits—
of balancing tracking error against a target index with customized
SRI objectives. Since marginal improvement in one
generally comes at the expense of the other, the trick is finding
an acceptable equilibrium—one client at a time.

“You can dial up or down your values system,” Geddes says
of his firm’s portfolio strategy. “You can have a very strict values
system with a lot higher tracking error, or we can show your
specific value set at a high, medium or low threshold. Basically,
our system’s telling you, ‘Here are your values at different value
levels, and here’s what it costs in terms of tracking error.’”

The crucial choice ultimately resides with the investor, who
must decide how much his particular SRI agenda is worth in
terms of replicating the target index. “If you want a higher social
score, you’re going to have to pay for it with a higher tracking
error,” explains Geddes. The good news, he tells Wealth Manager,
is that Aperio’s customized SRI indexing strategy generally cuts
tracking error in half while producing a modestly higher social
score (roughly 10 percent to 20 percent higher) compared to
competing SRI strategies, as the chart below illustrates.

“The traditional approach [to SRI] is excluding the companies
you don’t want, throwing them out, and cap weighting the rest,”
Geddes says. That’s inferior, largely because it doesn’t control risk
as well as Aperio’s strategy, he claims. No big surprise, perhaps,
considering that risk management is MPT’s raison d’être.

Geddes equates the relationship between SRI values and
tracking error with a modified information ratio (a risk metric
calculated as alpha relative to a benchmark divided by the
standard deviation of the alpha). “Basically, we’re operating
on a values ratio: Your SRI value score divided by your tracking
error. Investors want the biggest improvement in SRI values
for the smallest incremental cost of tracking error.”

The front line of Aperio’s strategy is quantifying investor
values in a way that meaningfully captures SRI views. The task
starts with a questionnaire informed by a social research database
from a firm such as KLD Research & Analytics, which
ranks companies on various SRI factors. Aperio interviews investors
on a series of SRI topics and runs the answers through a
database to quantitatively model the results. The stocks in the
target index are scored according to the client’s preferences.

“It’s an imperfect process because you can’t quantify everything,”
Geddes says of turning social scores into statistics.
“You might have a hot-button issue that we don’t have data
for, but generally we can get pretty far.”

Investors, it seems, can have their SRI preferences without
violating MPT. The message appears to be resonating with
some wealth managers and institutional investors. Aperio
manages $1.4 billion directly in separate accounts and consults
on another $6.5 billion with institutions. One convert
is Wetherby Asset Management, which reports that Aperio’s
flexibility in portfolio design is a big attraction. “You can be
as customized as you want in terms of investors’ wishes and
still do your best to track an index,” says Debra Wetherby,
CEO of her eponymous wealth management shop in San
Francisco. “We’re able to specify how important the various
tradeoffs are on a per-client basis” in terms of SRI values versus
tracking error.

The fact that Aperio doesn’t try to be all things to all investors
impresses another client. “They’re a pure play,” says Jeff
Colin, a founding partner of Baker Street Advisors, another
San Francisco wealth manager. “Their depth of expertise, as
a result, is on a par with significantly larger organizations.
That’s attractive to me.”

The broader lesson is that the warm and fuzzy world of SRI
isn’t immune to the quant revolution, or fated to be incompatible
with MPT. Anyone who thinks otherwise may want to give
Aperio a call.