Cleaning a Passive Index: How to Use Portfolio Optimization to Satisfy CSR Constraints

The emotionally charged debate regarding the broader role of corporations within society has landed squarely in the lap of pension fund and endowment trustees, many of whom are being pressured by their stakeholders to divest themselves of companies that lack so-called social responsibility. Some researchers claim that these companies are destined to mediocre financial performance given their irresponsible behavior and should rightfully be divested. A more traditional group argues that any attempt to second-guess the market by constraining the investible universe is itself destined to mediocrity. In this paper we take neither side of the debate. Rather, we illustrate how portfolio optimization can be used to locate statistical portfolio substitutes for investments and companies that fail a corporate social responsibility (CSR) screen. And, while the mathematics behind constrained portfolio optimization was developed more than 50 years ago, we find that the economic penalty for eliminating a small group of undesirable stocks - whether justified or not - is economically insignificant when the remaining investments are properly realigned. We illustrate the feasibility of this procedure with a cleansing process for the Canadian S&P/TSX 60 index, based on an employee practice CSR screen developed by Thompson and Wheeler (2004).