Rethink Investing – How to do socially responsible investing the right way?

Socially responsible investing, or sustainable, responsible and impact investing (both shorthand into SRI here), is “an investment discipline that considers environmental, social and corporate governance (ESG) criteria to generate long-term competitive financial returns and positive societal impact.” (defined by The Forum for Sustainable and Responsible Investment.) Sounds pretty good, doesn’t it? In fact, why aren’t all investments made this way?

Return with me to the beginning of this series where we rethink what investing means to us. We talked about how it is really about sharing our resources when we don’t yet need them, and receiving some return on taking a risk on others. In this context, SRI makes total sense for the first half of our mission – if we are sharing our resources, then we should have a say with whom and in what area we want to share.

The reservation for many comes from the second part. As an investor, you want to receive a return that is comparable to the risk you are taking. We talked about how the easiest way to ensure that is to take a globally diversified indexed approach in the long-term, meaning you are investing in a piece of the world, without discrimination, at all times, even though you don’t agree with how certain people live and manage their resources.

So now we have a dilemma. You are part of the world you live in now, but you are also responsible for creating the world of the future. How do we ensure our two objectives of investing are met at the same time?

Personally, I can live with myself by taking a globally diversified indexed approach with my investments, without considering ESG standards. My rationale is that how I live shapes the world I am in, but I also have no control over how others live. I could choose not to invest in oil companies, but I still use gas and electricity everyday; I could exclude weapon manufacturers in my investments, but I still rely on military and police to use them for my security. For me it’s hypocritical to reap the benefit of these products but object to their existence. On the other hand, I could kick the tobacco, alcohol and gambling industries out of my portfolio, but it doesn’t change the human conditions that turn people to vice. By investing in all, I take a stand and responsibility in the world I live in now.

I believe the more effective way to make a change in this world is through mindful consumption and personal connections. However, I understand the urge to also contribute to shaping a better future through your wealth. This is a challenge, and I applaud you for taking it on. Below is how I think you should go about it.

First I want to tell you what not to do. You might be thinking, “I’ll just exclude the companies that are really bad and invest in everything else.” This is not a very good idea. When you compare a social index that employs hard criteria to exclude certain companies to a market index, such as S&P 500, you’ll see that performance of the social index consistently lagged behind the market index, partially because it costs more to maintain a standard to exclude some companies than to simply invest in the market. What’s worse, you thought you were still investing in a well-represented index, but in fact your portfolio is heavily tilted toward technology and financial companies, because alas, those are the industries that have lower environmental impact, use little traditional manufacturing, and hire mostly white-collar workers. Is it really good for us to all flock to the two industries that created the last two big stock market bubbles? I don’t think so.

So what should you do? I believe that if you want to pick investments at all, be picky. The idea is for you to pick the winners that give you above market returns (to compensate for all the cost you put into picking them) AND have good environmental, social and corporate governance records. We already looked at how difficult it is to consistently beat the market trying to pick winners. By adding ESG as another criteria, you just make your task even harder, though not impossible. If you wish to make SRI investing, this is the way to go.

Financial winners are slightly easier to spot, because they are reported in hard numbers; not so with ESG data. Without the efficient access to information on every investable company and expertise to evaluate this information, it is likely you need to rely on managed SRI mutual funds. But how do you decide which SRI funds to invest in? Here are the three steps to help you find the likely candidates:

#1: Invest in a small number of companies that are truly profitable, under-appreciated, and also make a difference

Intuitively, if you impose more criteria in selecting stocks for a mutual fund portfolio in a limited universe, you will have fewer in the final pot. Not many companies will be currently profitable, undervalued, and have perfect and transparent ESG records at any given time. If you trust the managers enough to pick stocks for you and pay high expense ratio and fees for it, you should make sure PICKING is what they do.

Start by looking at the top 10-20 in the mutual fund holdings. Do they look more or less similar to the social index, or even with the market index? If so, the fund may have the same issue of tilting to certain industries, and performing like the market with potentially higher risks, because the companies in your portfolio may have more similar behavior during various market conditions.

Secondly, does the fund have a few hundreds of individual stock holdings like a social index? If so, it is also more likely to drift toward market performance, instead of beating the market. Ideally, the fund that goes through rigorous financial and ESG selection should come out with less than 100 individual stock holdings. In this case, it is still likely that the fund holds more stocks in technology and financial industries, but at least they don’t represent the market, and are expected to perform better than their peers in the same industry.

#2: Identify ESG criteria that meets your values and understand how they are defined

ESG criteria are generally qualitative, hidden, and subjective. There is a standard set of focus as reported by USSIF’s member organizations. However, each fund manager has its own proprietary ways to obtain information, determine what is good or bad (usually on a scale), and build its own scorecard. If a certain area of ESG is really important to you, you need to dig into the prospectus of the funds to find out whether they evaluate the companies the same way you like to evaluate them.

For example, you may think that climate change is something important, and you don’t want to invest in any company that has a certain level of carbon emissions. The fund managers think so too, but they may have higher tolerance levels for carbon emissions, especially if they are mandated to include an industry by picking the best ESG performer in the industry (but still worse than you’d like.) If PRI investing is a matter of value to you, you need to really make sure the funds you invest in match your values in practice.

In addition, an ESG centric company can care about one area more than another. Mutual funds may also choose to focus on certain areas, like imposing much higher standards on environmental protection but average standards on labor relations. You need to do your due diligence on whether the funds invest in a way that is truly up to your expectation.

#3: Know why you want SRI in the first place

There are many polls showing that more people care about incorporating SRI investing in recent years, but there hasn’t been one detailing the reasons. Do we just want to feel better about ourselves? Do we want to put our values into practice but care less about the outcome? Or do we actually expect a positive impact from our investments while making at least equal returns as those not practicing SRI?

For those in the third group, you need to engage in more than just finding a few mutual funds, then forgetting about it. You actually want to encourage everybody to do the same and involved in shareholder advocacy, so only companies with a good ESG record survive. Unfortunately, that means the stock price for these good companies will become too high for them to be good investments, so you need to constantly search for new investment targets. This represents another dilemma – you actually don’t want everyone to practice SRI the right way so you can “beat the market”; but if others don’t practice SRI, you are less likely to make a real impact. (Here is another good argument about how in theory SRI may not have an impact on the companies themselves.)

Has SRI investing actually made the world better? There is documented evidence, but no real studies on whether the SRI movement is the reason the companies are adopting higher ESG standards. Can it be profitable? Yes, if you do it the right way. It is unlikely as simple as some claimed that high ESG standards are predictors of long-term profitability so you don’t have to look at other financial fundamentals of the companies. Moreover, we know that it is difficult to sustain above market performance in the long run, given the high expenses associated with picking stocks. If this is still the route you want to take, be prepared and do your due diligence.

The latest estimate shows that there are over 900 mutual funds in the US that practice some kind of ESG screening. However, there are only roughly 200 right now listed on the USSIF website by its members. I suggest that you start there and look through the screening and advocacy tab. Another resource, SocialFunds.com, allows you to further sort by the ESG screening criteria, so you can find the ones that match your values and focus. Then apply the #1 and #2 steps that I have discussed above.

When I went through this exercise earlier this year, I only found one fund that met all my strict standards and had above long-term average performance post-fees. (Then again, I don’t know if the long-term manager will retire soon and depart, taking his expertise with him.) You may find different sets of funds that meet your criteria. I hope this post gives you the guidance to find the right SRI funds for you.