Investing for Good: Socially Responsible Investing

“Every time you invest money you're casting a vote for the kind of world you want."
― Anna Lappé, author

In the last few years, the buzz about socially responsible investing (SRI) has been rolling through the investment world. Money has poured into socially responsible funds. Investors want to know whether their investments are contributing to positive change in the world. A recent study found that 40% of financial advisors say that SRI is important to them and their clients. What’s more, interest in SRI went up a whopping 90% in the 3 months after Donald Trump was inaugurated.*

Four Questions

Today we’ll dive into four questions to map an overview of socially responsible investing.

  1. What criteria are used to measure the social responsibility of a company?
  2. How are socially responsible mutual funds and ETFs built?
  3. How does SRI differ from impact investing?
  4. How well do socially responsible funds keep pace with their non-SRI counterparts?

To close, we’ll briefly discuss your investment options if you would like to pursue SRI investing.

How does one go about qualifying the degree to which a company is evil or good?

Alphabet dropped Google’s “Don’t Be Evil” motto from its code of conduct in 2015. But exactly how can we measure good and “evilness?”  The factors commonly used to assess social responsibility fall into three broad categories of environmental, social, and governance (ESG). Environmental concerns address a company’s relationship with this earth. Primary environmental issues include pollution and climate change, nuclear energy, and sustainable resource use. Concern with social issues addresses diversity, gender issues, human rights, as well as the health and wellbeing of a company’s international workforce and the communities in which it does business. Finally, responsibility in corporate governance covers employee relations as well as executive compensation and management structure—how is power balanced among a board of directors, CEO, stockholders, and employees?

Some business sectors may excel in one area of ESG and struggle in other areas. Garment manufacturers weigh the cost of production against fair wages and healthy work conditions, while mining companies balance resource extraction with habitat protection. Key to our discussion is the comparison of companies from like sectors. In evaluating social impact, for example, could we really compare the labor practices of Apple against Nike or Facebook? Tech workers in Silicon Valley and garment manufactures in Indonesia each have different needs and expectations relative to their environment. And it is not easy to compare domestic with outsourced labor markets, for example.

How are socially responsible funds built?

Large institutional investors historically dominated the early ESG investing scene. Over time some niche mutual fund companies began to build socially responsible funds available to consumers, and now almost every major investment bank has created their own ESG-sensitive product offerings. Traditionally, socially responsible funds were either built using a negative screen or best-in-class inclusion approach, both of which we’ll look at now.

At face value, the negative inclusion screen is one of the simplest to understand. Say a mutual fund company wanted to create a socially responsible fund using companies chosen exclusively from the S&P 500. According to the fund’s pre-set criteria, companies in certain industries (i.e. those in tobacco, oil, history of child labor etc.) would be excluded.

Realizing the limitations of this approach, a best-in-class system was then developed in the investment community. Rather than rejecting companies according to industry or one black-eye factor, a fund manager might choose elements from areas of environmental, social, and governance to arrive at a best-in-class choice. Companies are selected from the variety of sectors and industries. So while an exclusionary model might reject all oil companies, a best in class approach would compare companies like Exxon, Shell, and Chevron, and invest in the stock of the company that exemplifies the best adherence to the mutual fund’s standard for sustainability.

Investing in Activism

Funds may also incorporate an activist approach. They will exert pressure on the companies in which they invest by utilizing proxy voting on behalf of the fund investors. Traditionally this is a strategy of large hedge funds. They will acquire a significant share of the company’s voting stock in order to oust a CEO or leadership team and transform the company in order to build value.

In less dramatic fashion, ESG funds can use similar strategies. By pooling the proxy votes of all the owners of a fund, the fund managers can exert pressure on the stock of each company included in the fund in favor of best ESG practices. . This proxy voting means that owning a piece of a company in an S&P 500 fund with an ESG mission may actually have different results than if you own the same amount of that stock within a different mutual fund without a sustainability mandate. As an example of what this might look like in practice, check out Dimensional Fund’s explanation of their approach to proxy voting that includes social responsibility concerns.

One of the ongoing challenges investors and fund managers run up against is that most sustainability data is self-reported. Companies choose which data they will share and how they will share it. Sifting through, interpreting, and comparing this information is time-consuming. As a result, management fees for socially responsible funds tend to be higher than those for their traditional simple bottom line counterparts.

What is the difference between socially responsible and impact investing?

Socially responsible investing typically uses a set of screens to assess publicly traded companies for investment. Impact investing reviews the primary mission of the companies. It aims to invest in companies whose vision includes positive social or environmental results. While socially responsible funds are often passive in nature, impact funds usually track and report the non-financial impact of their investments. In 2009 the Rockefeller Foundation, U.S. government, and investment managers began to define a set of social and environmental metrics to codify best practices for impact reporting. This developed into the IRIS framework which is now a standardized system used by investment funds to measure and report the non-financial performance of managers and strategies.

What About Returns? Can Socially Responsible Funds Keep Pace?

One of the biggest questions in the discussion about socially responsible investing concerns performance. Can a socially responsible fund keep pace with a similar fund without the same higher mandate?

A study by Morgan Stanley including over 10,000 mutual funds concluded in 2014 that “investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments. This is on both an absolute and a risk-adjusted basis, across asset classes and over time.” Morgan Stanley found that the common S&P 500 sustainable benchmark counterpart (the MSCI KLD 400) outperformed the S&P from 1990 to 2014 by almost half a percent, although management fees were not taken into account.

“Why?” we might ask. The devil is in the details of each company’s specifics, but generally it makes sense that companies that reduce waste, utilize natural resources more efficiently, hold exemplary safety ratings and experience higher company morale and less employee turnover have advantages over their counterparts. Not surprisingly, for example, the 100 Best Companies to Work for in America beat their peers in profitability by 2.3 to 3.8 percentage points a year from 1984 to 2011.*

Socially responsible strategies can also reduce regulatory risk (for example, from a new tobacco tax, or an imposed environmental mandate) and thereby lower volatility. Volatility is a key contributor to risk. Lower volatility combined with better performance thus offers investors both a greater return and less risk – success on two fronts!

While these socially responsible funds are still relative newcomers on the scene of stock market investments, initial results of the underlying investments are encouraging. But while the companies themselves appear to outperform their counterparts, the SRI funds available to investors tend to carry higher fees which may give back some or all of their superior performance gains. Over the next years it will be interesting to observe how SRI funds continue to perform. I’m encouraged by where we have come so far and I am excited about the future.

Your Investment Options

So where does this take you in practice? There is no one overarching standard of how to construct a socially responsible fund, which means that the variety of investment options is only limited by the number of fund managers who are willing to create their own ‘special sauce’ and their imaginations. There are both highly managed strategic funds and passive funds, generally with quite different percentage points going to fund management fees. A mutual fund’s prospectus details the fund’s investment strategy and holdings, and is the best place to start your research.

If you’re interested in diving into details you might look at Vanguard’s FTSE Social Index Fund (VFTSX), which tracks roughly 400 of the largest US based companies, using negative screening (excluding alcohol, tobacco, etc.) as well as looking for positive traits (human rights values and female board members.)

Another option is Flexshares STOXX US ESG Impact Fund (ESG), which takes a best-in-class approach. ESG’s managers select the top 50% of stocks from a pool of 1,800 based on specific Key Performance Indicators. Interestingly, by taking a “best-in-class” approach, the ESG fund includes tobacco companies such as Altria and Phillip Morris, along with investing over 3% of the fund in Exxon Mobile and Haliburton. Other companies, such as Johnson & Johnson, Home Depot, and Comcast remain absent because they are not considered best in their class from the perspective of social responsibility.

In Closing

I hope you’ve enjoyed this survey of socially responsible investing. Hopefully your time reading has provided you with helpful knowledge about how SRI funds are created as well as a vocabulary for discussing and exploring further how your own vision and values might be reflected in your investments. If you have further questions, or want the next post to answer a burning question in more detail? Say hello, and we’ll give it a shot.

Further Reading:

The Wall Street Journal ran an article last year pitting arguments from a professor at the London Business School against another from UC Berkeley in which they debated whether socially responsible investing makes financial sense. Their dialogue enriches our discussion here and contributes to a fascinating ongoing debate.

For further reading into one asset managers vision for their socially responsible ETF’s you might be interested in Flexshares white paper on the topic.