Some people believe that unscrupulous means are sometimes necessary for making gains in a portfolio. However, it is possible to profit while using an ethical investment strategy – and you don't need to join Greenpeace in order to do it. Here we'll take a look at socially responsible investing (SRI) and how you can use socially responsible mutual funds to activate this strategy in your portfolio.
The U.S. Department of Labor released a new regulation in late October 2020 that may limit or eliminate socially responsible investing in retirement plans. While the rule was revised to remove explicit references to environmental, social, and governance (ESG) factors, it mandates that fiduciaries of retirement plans choose investment strategies based entirely on how those strategies affect financial performance. This ruling may have a significant impact on funds and investments classified under ESG and socially responsible investing.
What Is Socially Responsible Investing?
A socially responsible investing strategy is one that views successful investment returns and responsible corporate behavior as going hand in hand. SRI investors believe that by combining certain social criteria with rigorous investment standards, they can identify securities that will earn competitive returns and help build a better world.
SRI analysts gather information on industry and company practices and review these in the context of a country's political, economic and social environment.
Generally, these seven areas are the focus of socially responsible investors:
- Corporate governance and ethics
- Workplace practices
- Environmental concerns
- Product safety and impact
- Human rights
- Community relations
- Indigenous peoples' rights
It should be noted that socially responsible investing is essentially interested in promoting adherence to the positive aspects of these areas with publicly-held companies. However, SRI also gets a lot of attention for industries and companies that it opposes as "bad" for society. The latter would include, among others, businesses involved in gambling, tobacco, weapons, and alcohol. These so-called "sinful" investment categories are often eliminated through SRI screening.
What Are Socially Responsible Mutual Funds?
Socially responsible mutual funds hold securities in companies that adhere to social, moral, religious or environmental beliefs. To ensure the stocks chosen have values that coincide with the fund's beliefs, companies undergo a careful screening process. A socially responsible mutual fund will only hold securities in companies that adhere to high standards of good corporate citizenship.
Because people hold such a wide variety of values and beliefs, fund managers have quite a challenge in determining the stocks that reflect the optimal combination of values for attracting investors. The specific criteria used when screening for stocks all depend on the values and goals of the fund.
For example, funds with a strong sensitivity toward issues of environmental concern will specifically pick stocks in companies that go beyond fulfilling minimal environmental requirements. (For more insight, read Go Green With Socially Responsible Investing.)
Many socially responsible mutual funds will also partition a portion of their portfolios for community investments. A common misconception is that these investments are donations. This is not the case. These investments allow investors to give to a community in need while making a return on their investment. Many community investments are put toward community development banks in developing countries or in lower-income areas in the U. S. for affordable housing and venture capital.
Ownership Is Taken Seriously
Shareholder activism is one of the most important issues for socially responsible funds. SRI funds use their ownership rights to influence management through policy change suggestions. This advocacy is achieved by attending shareholder meetings, filing proposals, writing letters to management and exercising voting rights.
Because it is difficult for fund shareholders to exercise their votes, voting is achieved by proxy; fund shareholders assign management to vote on their behalf. Most socially responsible mutual funds have a strict policy to maintain transparency in their decisions and disclose all proxy voting policies and procedures to their shareholders.
Proof that individuals can make a difference is illustrated by the proposal the Securities and Exchange Commission (SEC) passed in January 2003, which states that all mutual fund companies must disclose proxy voting policies and procedures and the actual votes to their shareholders. The SEC's decision was brought about by the thousands of proposal requests sent to them by socially responsible investors.
Does Good Triumph Over All?
As an investor, you cannot be completely philanthropic and expect nothing in return for your investment other than that pure feeling of having invested in a company that reflects your own values. So how does the performance of socially responsible mutual funds measure up to that of a regular portfolio? On average, its performance has been close to that of regular mutual funds. There are several indexes that track the performance of stocks considered to be socially responsible investments. According to KLD Indexes, the annualized returns for the MSCI KLD 400 Social Index (initially called the Domini Social 400 Index) between May 1994 (its inception) and June 2018 was 10.01%. Over the past 10 years, the index has delivered a 10.63% annualized return compared to a 10.17% annualized return from the S&P 500.
The Price of Doing Good
Socially responsible mutual funds tend to have higher fees than regular funds. These higher fees can be attributed to the additional ethical research that mutual fund managers must undertake. In addition, socially responsible funds tend to be managed by smaller mutual fund companies and the assets under management are relatively small. Under these circumstances, it is difficult for SRI funds to make use of the economies of scale available to their larger rivals.
Keep a Level Head
Before you let your emotions become your investment advisor, it is wise to maintain a level head. Here are some important tips to follow in order to maximize your chances of earning decent returns and investing in qualified socially responsible funds:
- Get Informed – Learn about socially responsible investing, which funds qualify and where you can buy them. Socialfunds.com is a good place to start your research.
- Know Your Values – Everybody's values are different. Some may feel strongly about environmental causes while others are more concerned with social programs. Rank your concerns. Once you have established a few top values, you may narrow your fund choices down to a few select funds whose values closely match your own.
- Go Beyond Your Values – Research the fundamentals and fees of the funds in which you are interested. Some items to consider include the level of the management expense ratio, the cost of load fees, the fund manager's track record and how the fund has performed over the last few years. There is no need to sacrifice investment quality when considering an SRI fund. Do your homework as you would for any fund investment. (Visit our Mutual Fund Basics Tutorial for further tips and information on mutual funds.)
- Diversify – A consequence of investing in SRI funds is that you may be limiting your investment to a few companies who have a lot in common socially, ethically and financially. Think of a sector fund with a portfolio formed mainly from stocks in the internet industry. If you had all of your eggs in this basket during the internet market crash, all your eggs would have been broken. If your investment is placed strategically in different types of investments, the possibility of losing all of your investment is minimal. If you want to be a socially responsible investor, it is still possible to diversify your portfolio with other stocks, bonds or Treasuries without going against your values. Investing in socially responsible securities with values that differ somewhat from the specific focus of your chosen fund can help.
The Bottom Line
Socially responsible investing opportunities suggest that investors need not compromise their values to make money. If you approach socially responsible mutual funds like any other investment, you may be able to put your money into something that both supports your values and lines your pocketbook.