Socially responsible investing (SRI), also known as values-based or ethical investing, is an investment process that considers social and environmental factors, both positive and negative, within the context of securities and investment analysis. Social investment managers often use social and environmental analysis in conjunction with traditional quantitative securities analysis to make their investment decisions. In this article, we'll go over this investment process and show you what socially responsible investing can do for your portfolio.
TUTORIAL: Financial Concepts
Religious and Political Roots
The foundation of SRI lies in religious law. It began as a confluence of morals and money that goes back at least to Biblical times when Jewish law had directives on how to invest according to ethical values. More recently in the United States, Quakers practiced socially responsible investing based on their beliefs in human equality and non-violence.
In general, religious investors wanted to avoid investments in companies involved in addictive substances and behavior: alcohol, tobacco and gambling. Some religions also wanted to avoid weapons-making companies. Although there are still many socially responsible investors that are guided by religion, many other investors aligned with SRI invest their money in an environmentally focused manner. More recently, clean-tech investors (or green investors) have moved into the SRI arena as they look for companies involved in clean energy or other technologies that balance the interaction between humans and the environment. (To read more on this topic, see Working With Islamic Finance and A Prelude To Sinful Investing.)
The shift in SRI from a purely religious or faith-based focused investment approach to one with a broader perspective got a jump-start with the South Africa divestiture movement in the 1970s and '80s. In that situation, investors were unwilling to hold positions in companies that were benefiting from South Africa's Apartheid policy.
Go Green, Man
From the flower child of the '70s to the green politicians of the new millennium, the increase in environmental awareness has played a major role in the increasing appeal of SRIs to a wide group of investors.
Because there are many different viewpoints on what constitutes the proper values to seek in companies, it is difficult to provide a universal definition of SRI. For some investors, being socially responsible means not investing in companies involved in alcohol, while for others, alcohol is perfectly acceptable. The most commonly screened companies are those involved in tobacco, which is almost universally seen as detrimental. (To find out more about stock screens, see Getting To Know Stock Screeners.)
One of the first mutual funds to incorporate socially responsible screening was the Pioneer Fund (PIODX), which has avoided the stocks of companies whose primary business is alcohol or tobacco since 1950. The market has expanded since then so that there are more than 200 mutual funds and roughly a half-dozen exchange-traded funds that invest using one or more social or environmental criteria. There are now SRI funds that are balanced, focus on equities, seek international securities, invest in bonds, track indexes and invest in money market instruments. (To read more about SRI funds, see Socially Responsible Mutual Funds, Socially (Ir)responsible Mutual Funds and What is a "socially responsible" mutual fund?)
Social investors use five basic strategies to maximize financial return and attempt to maximize social good:
This is the filtering process used to either identify certain securities to exclude or to find those that should be included in investors' portfolios based on social and/or environmental criteria.
2. Negative Screening
The original focus of SRIs was to avoid investments in companies engaged in undesirable activities, whether it was a beer brewer or tobacco manufacturer. These negative screens exclude certain securities from investment consideration based on social or environmental criteria and can preclude investing in tobacco, gambling, alcohol or weapons manufacturing.
3. Inclusionary/Positive Screening
Inclusionary or positive screening favors investments in companies that have strong records in a particular area such as in the environment, employee relations or diversity. Screening individual companies in an industry on social and environmental grounds highlights the records of individual firms relative to their peers. This screening technique grew out of the negative screening process. As avoidance screens became more sophisticated, some investors began to realize they could actively seek out and include companies with desirable characteristics in their portfolios, rather than simply avoiding companies.
Extensive evaluations of corporations' business practices are now commonly performed so that companies are often assessed to determine how sustainable they are as businesses and whether or not they are having a high and positive social and environmental impact.
Positive screening is often used to support underserved communities in areas such as mortgages or small business credit.
Divesting securities means to remove selected investments from a portfolio based on certain social or environmental criteria. On Wall Street, there has always been the belief that if you don't like how a company is run you can simply sell your stake and move on - the so-called "Wall Street Walk". Although this may sound simple and elegant in theory, the reality is that there are always transaction costs related to moving into or out of a security. Furthermore, many institutional investors hold such large positions that it can be extremely difficult and expensive to simply sell out of them.
5. Shareholder Activism
Shareholder activism attempts to positively influence corporate behavior in the belief that the cooperative efforts of social investors can prod management to steer a more responsible social and/or environmental course. These efforts can include initiating conversations with corporate management on issues of concern, along with submitting and voting proxy resolutions. Issues such as overseas labor, discrimination, marketing practices and CEO compensation are often questioned in the belief that changes will improve financial performance over time and enhance the well being of the stockholders, customers, employees, vendors and communities.
SRI advocates argue that screening helps eliminate companies that have risks not generally recognized by traditional financial analysis. Critics take the stance that any approach that reduces the universe of potential investments will result in a sacrifice in performance. No doubt the debate will continue, but there are several reasons to have confidence that investing in a socially responsible manner does not have to mean a reduction in returns.
The record of the Domini 400 Social Index (DSI) is an indication that socially responsible investors do not have to automatically assume a sacrifice in performance for following their values. Created in 1990, the DSI was the first benchmark for equity portfolios subject to multiple social screens. The DSI is a market capitalization-weighted index modeled on the Standard & Poor's 500 and has outperformed that unscreened index on an annualized basis since its inception.
In a paper entitled "Socially Responsible Mutual Funds", published in the May/June 2000 issue of the Financial Analysts Journal, Meir Statman of Santa ClaraUniversity reviewed 31 socially screened mutual funds and found that they outperformed their unscreened peers, but not by a statistically significant margin. The bottom line appears to be that SRI funds do not behave all that differently from regular funds and that investing in a SRI fund will not negatively affect your returns compared to choosing a conventional index fund.