Because of one of the sandboxes I play in (younger professionals looking to grow their wealth), I encounter frequent questions about socially responsible investing (SRI).
This is the concept whereby an investor screens out a number of companies from his or her portfolio based on personal (usually ethical) opposition to some of the business practices of that company. Favorites for this type of treatment are fossil fuel companies, big pharmaceutical firms, cosmetics companies, casinos, weapons manufacturers, and alcohol or tobacco producers. But it can be anything.
Wall Street, never one to miss a trick when it comes to manufacturing a product that it can sell to a particular demographic, has created SRI funds, which it dangles in front of investors, promising no ownership of, say, gun manufacturers within the holdings of the fund.
Some funds also add what they call a "positive screen," so not just keeping the “bad” companies out of the portfolio, but over-weighting companies that they consider to be “good” from an SRI standpoint.
The Problems With Socially Responsible Investing Funds
There are three main problems with these funds.
1. They are generally expensive. Someone, somewhere has to take the time and make the effort to conduct the initial pre-screen for these funds and then monitor them to ensure that they do what it says on the label. Guess who pays for that? That’s right, the investor who buys the fund.
Annual expense ratios for SRI funds can be hundreds of percentage points more expensive than broad, unfiltered index funds. For example, the Calvert World Values International Equity C fund (CWVCX) carries an annual expense ratio of 2.14%. This compares to the Schwab Broad Market ETF (SCHB) which costs 0.03% per year. This SRI fund costs you about 70 times as much to own as the broad market fund, every single year. Do the compounding math on that one and you will see what enormous damage you can cause to your wealth by owning such an investment.
2. SRI funds often underperform, sometimes very significantly. Right away, by paying the exorbitantly more expensive fees associated with these funds, your odds of underperforming the broad market shoot right up (probably to the 95-99% range over longer periods of time in the case of funds that charge more than 2%, like the example above). But it can get worse. Depending what you are screening out of (and into) your portfolio, the returns on these funds can lag the broad market, even before the higher fees are taken into account.
The investor is taking a higher degree of concentration risk in the portfolio as it becomes less diversified, not just because of the exclusion of a number of stocks, but sometimes virtually an entire sector. (For related reading, see: When Socially Responsible Investing Hurts.)
By way of an example, Vanguard's FTSE Social Index Fund (VFTSX) has recently returned on average about 2% less per year versus Vanguard's Total Stock Market ETF (and it carries higher fees). On a compounded basis, that is a massive shortfall that can meaningfully impact when you can retire and with how much.
3. The fund provider decides what is “bad,” not you. The criteria for what exactly constitutes SRI is intensely personal. SRI funds come “pre-packaged,” in other words, you do not get to choose exactly what is excluded or over-weighted in the holdings of these funds. They come with sweeping, broad names like “World Values” and “New Vision” and may well be excluding or including the stock of companies that do not conform to your perception of what should be included or excluded. Maybe they are excluding retailers whose stores sell tobacco products, yet including pharmaceutical firms that conduct animal experiments. Maybe they are excluding firms that produce weapons, but including firms that buy those weapons. (For related reading, see: The Evolution of Sinful Investing.)
The point is that it is virtually impossible to find a fund that conforms exactly to your vision of precisely what should or should not be excluded or included in a portfolio.
SRI Does Not Affect a Company's Bottom Line
But the most important thing to understand when it comes to SRI arises from a misconception of what buying a stock actually means. By making the decision to buy or not buy a company’s stock, you are having zero effect on the company’s worth. In other words, if your goal is to punish a firm by not buying their stock, it is a message that will never be heard. Equally, if you do buy their stock, you are not giving the firm anything.
Here’s what I mean...
If you buy 100 shares of, for example, Exxon Mobil (XOM) at, say, $80.00 per share, you are not giving Exxon $8,000 when you pay for those shares. Exxon is not $8,000 better off as a result of you doing that. This is what is very often misunderstood.
Those shares currently belong to someone else. You are not buying them from Exxon, you are buying them from another investor. You are giving your $8,000 to that other investor, not to Exxon, who only received the funds at the initial public offering (IPO) of the stock decades ago. They have long since ceased to care about who owns their stock.
All that happens when you buy these shares is that the record of ownership of 100 shares is electronically transferred from the previous owner to you. Exxon does not benefit from the transaction in any way. As far as they are concerned, the record of the list of their shareholders has been ever so slightly and temporarily amended, as it is millions of times every single trading day as their shares change hands. They do not know, or care, whether you own their stock or not.
Equally, you not buying the shares has absolutely no effect on Exxon either. Someone else unrelated to Exxon (an individual, an investment bank, a day trader, etc.) already owns those shares. Exxon doesn’t. By you simply choosing to not buy shares from that current owner, you are not sending any kind of message to the board, nor are you negatively impacting Exxon’s bottom line in any way. (For more from this author, see: Why Stock Picking Is a Loser's Game.)
The company has no idea that you chose not to buy their shares and will feel no pressure to change any of its practices as the result of an action (or inaction) that it does not even know about. That current owner of the shares will simply continue to hold on to them until someone else comes in and buys them from him and a microscopic change is then made to the shareholder roster for a few nanoseconds until the next trade happens.
How to Send a Message to a Company
So how do you send a message to a company if buying expensive, underperforming SRI funds is not the answer?
Here’s a suggestion...
First, identify an organization that is active and effective in opposing the policies of the exact subset of companies with which you have a problem. These may be large organizations like Greenpeace, UNHCR, Planned Parenthood or the World Wildlife Fund, or they may be smaller, more local or micro-issue-focused organizations. The size and nature of the organization is not important, all that matters is that you are convinced that a) it focuses and advocates on precisely the issue you care about and, b) it is effective in doing so.
Next, work with your certified financial planner (CFP) on a diversified exchange-traded fund-based asset allocation for your investments that is completely agnostic when it comes to particular company holdings and whose composition is driven exclusively by your personal needs, goals, objectives, risk tolerance and time horizons, and is as optimized as possible from both a cost and tax perspective.
At the end of the year, talk to your CFP about the companies you have a problem with. Provide him or her with a list of those companies and ask that they go into your account and calculate exactly how much, if anything, your investments in these companies have generated to you over the course of that year. Any decent CFP will do that for you.
Then turn around and make a (possibly tax deductible) contribution of exactly that amount to the organization that you have identified earlier as most optimal and effective for opposing the target companies' practices. You can legitimately claim that you have not personally profited at all from your ownership stake in those particular companies. (For related reading, see: Give to Charity; Slash Your Tax Payment.)
This way, you have potentially contributed to actually punishing them in a laser-focused manner by means of your donation, while your ownership of their stock over the course of the year has accrued no advantage to the target company. All without making a Wall Street fund provider rich by overpaying for some SRI fund.
The use of SRI funds results in activists becoming poorer while Wall Street becomes richer. I'm not sure that is particularly helpful from the perspective of those who are looking to help enable social change.
(For more from this author, see: Protect Your Future Wealth From This Big Mistake.)