Socially responsible investing with KLD:: What if they launched an ETF and no one came?

A recent article in Institutional investor discussed the seeming lack of interest in socially responsible ETFs. Specifically the iShares KLD Select Social Index (KLD). The KLD index is based on the Russell 1000 index, with tobacco companies excluded. The index methodology then uses an optimization scheme to favor socially responsible companies while not having more than 2% tracking error to the Russell 1000 index.

• Yahoo! Finance graph of KLD vs IWB

Looking at the funds performance over the past year KLD's quantitative strategy has been quite successful at matching the benchmark index. The very low trading volume relative to the number of KLD shares outstanding can easily be explained by most owners of KLD being buy-and-hold types rather than active traders. (SDY) also has ridiculously low volume relative to size for the same reason.

I think the main reason for lack of interest in socially responsible funds is that most investors agree with economist Milton Freedman that the social responsibility of business is to increase its profits. Indeed according to Prof Jeremy Siegel, Ben Bernanke's Favorite Stock is Altria (MO) (f/k/a Phillip Morris).

Socially responsible investing suffers from socially desirability bias, the tendency for people to claim things about themselves which are socially desirable. A classic example is flossing your teeth; most people when asked will claim that they do floss their teeth, even though in reality regular flossing is quite rare.

The article notes that "according to Calvert, more than half of all non-SRI investors are “interested” in putting money with socially responsible funds, and almost 40% of investors consider themselves socially responsible, the share of investors in socially responsible investments range from 2% to 11%, depending on who you ask." I could be snarky, by noting that 2% to 11% is probably the same proportion of the population that drives Volvo's, contributes to NPR, or thinks the BBC is Fair and Balanced, but that would be cheap and I won't do it.

The article also lumps together the Powershares WilderHill Clean Energy Portfolio (PBW) with KLD. I feel that most investors owning PBW are doing so because they believe that increased fossil fuel prices will drive growth in the clean energy sector. Interest in PBW is driven by greed, not moonbeams.

The other big picture item that article seems to miss is that now that the broad asset allocation (I.e Large Cap, Small cap, Bonds, REITs etf) area have been covered by ETFs, future ETFs are going to be narrower and focus on themes and gimmicks. Which is exactly what has happened in the strictly retail UIT sector which is a ministry of all the talents.