Socially responsible investing (SRI) is an investment process that considers social and environmental factors within the context of traditional quantitative securities and investment analysis. In this article, we'll review SRI investing and what it can do for your portfolio.

Key Takeaways

  • Socially responsible investing considers the social and environmental impact of any investment.
  • Early socially minded investors avoided alcohol, tobacco, gambling, and weapons-making businesses. Later, socially responsible investors avoided companies that invested in South Africa during apartheid.
  • Screening for socially responsible investments doesn't necessarily come at the cost of investment performance.

Religious and Political Roots

SRI traces its roots to religious practice. In the 1800s, religious investors avoided businesses involved with alcohol, tobacco, gambling, and weapons making. In the 1970s and 1980s, opposition to the Vietnam War and apartheid in South Africa helped to establish socially responsible investment practices as we know them today.

In 1982, Calvert Social Investment Fund became the first mutual fund to prohibit investments in South Africa, setting the stage for the divestiture movement opposed to that country's system of racial inequality.

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. This stems from the growing recognition that uneconomic growth is having serious negative social and environmental consequences, and capital should support growth that is more sustainable.

Socially Responsible Investing Goes Mainstream

Because not everyone holds the same values, it is difficult to provide a universal definition of socially responsible investing. Some investors oppose investing in companies involved with alcohol, while others enjoy a good tipple and find investments in alcohol perfectly acceptable. However, there are some investments for which there is near unanimity among the socially conscious. Tobacco, for example, is almost universally disdained.

In 1950, Pioneer Fund became the first mutual find to screen for sin stocks such as alcohol, tobacco, and gambling. Founded in 1928, the Pioneer Fund avoided such investments throughout much of its history, though its prospectus did not formally impose this criteria until July 2018.

Mutual funds and exchange-traded funds (ETFs) that adhere to an environmental, social, and governance (ESG) criteria are now commonplace. A mutual fund and ETF screener operated by Mitre Media turns up more than 1,300 choices in the ESG equity category.

Social investors use five basic strategies to maximize financial return and social good:

Screening

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.

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.

Inclusionary/Positive Screening

Inclusionary or positive screening favors investments in companies that have strong records in a particular area such as 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.

Divestiture

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.

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.

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, excessive executive 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.

The Bottom Line

SRI advocates argue that screening helps eliminate companies that have risks not generally recognized by traditional financial analysis. Critics, however, say any approach that reduces the universe of potential investments will result in sacrificed performance. No doubt the debate will continue. But there are reasons to believe that investing in a socially responsible manner does not necessarily mean a reduction in returns.

The track record of the MSCI KLD 400 Social Index suggests that socially responsible investors do not need sacrifice performance for following their values. Created in 1990, the index was the first benchmark for equity portfolios subject to multiple social screens.

For example, the iShares MSCI KLD 400 Social ETF uses the index as its benchmark and returned 20.81% in 2020. This compares to the 18.37% one-year return for the iShares Core S&P 500 ETF, which is based on the S&P 500 Index.