Socially Responsible Investing

Take a look at the whole picture by Peter Eickelberg, CFA

Socially responsible investing (SRI) refers to several strategies that attempt to address an investor's social, moral or religious values during the investing process. If you are thinking about putting your money where your values are and purchasing funds that identify themselves as SRI (or use a similar label like "socially aware," "socially conscious," etc.), you should consider carefully how these investments will impact your overall portfolio's risk. In some cases, a particular SRI investment may fit the bill perfectly; but in other cases, you might discover a more efficient strategy for making the world a better place.

The recent proliferation of innovative, social-issue-focused investment funds has empowered investors who wish to avoid "hot-button" issues like tobacco, child labor, gambling, pornography, pollution, and defense products, to name some of the most popular. Understandably, someone zealous to rid the world of gambling does not want his or her money supporting casino stock prices. Investing to avoid particular companies or industries is known as "exclusion" SRI. Exclusion fund managers sometimes follow an absolute prohibition on companies involved in the undesirable activity; but sometimes, to be practical, the fund's objective permits it to invest in companies that maintain a certain maximum involvement. For example, a hypothetical "tobacco-free" fund might still buy stock in a grocery chain whose stores sold cigarettes as long as tobacco represented only a small percentage of the stores' revenue. If you feel that exclusion investing is the way to go, you should understand and be comfortable with the level of exclusion offered.

Two other SRI strategies growing in popularity include "best in class" investing and the "engagement" approach. Best in class managers actively select companies they feel will benefit financially over the long run by having "better" business practices. For example, perhaps consumers will favor a "green" company over its competitors so that the former's earnings increase long-term. Or maybe the extra care management shows to social issues indicates superior overall management, which may lead to higher company profitability.

By contrast, engagement funds purchase shares in the companies they wish to influence and then use their ownership position to bring about change. Engagement can be confrontational (involving shareholder demands on current management, sometimes also called "advocacy") or constructive (whereby owners talk to management and try to get them on board with their values).

Because these latter approaches require staff to research companies and communicate effectively with company management, expect fund costs to reflect the overhead. Expenses tend to correlate negatively with relative fund performance, so you should be confident the approach you choose merits the costs or else view it as an investment in a better future. To be fair, effective engagement could actually help reduce broad-level economic costs elsewhere if firm management practices improve as a result.

At least two major drawbacks apply to SRI. First, it may be difficult to find a fund that fully reflects your values. (For example, a fund may avoid defense products and tobacco when the investor opposes only the latter. Or a fund may omit an important exclusion or be active in promoting an undesirable cause.) In time, this problem could abate as new funds come to market.

Second, because some funds leave out entire industries (or the largest players within those industries), their composition can differ significantly from that of major indices. If you target average market returns and volatility, an SRI fund could disappoint. Excluding an industry may result in higher-than-market returns over short periods for a fund, but industry performance is cyclical: traders will almost certainly favor the excluded industry in some future period.

Additionally, if you have built your portfolio using an index-based modeling tool (like your broker's asset allocation charts or your advisor's Monte Carlo analysis), you should realize that these tools typically rely on broad market risk and return characteristics. These tools become less powerful when your planned portfolio won't hold all the stocks in the index.

Most SRI funds explicitly or implicitly follow active investment strategies. The astute investor will recognize, for example, that "best in class" implies the overall market has not fully incorporated available information into stock prices. Such an assumption runs counter to passive investing strategies (e.g., indexing), and abundant evidence supports the view that active security selection fails to add value after trading costs and taxes. Therefore, until research demonstrates otherwise, most investors should probably look to SRI for how it can help them express personal values and not hope for superior investment returns.

Other Ways to "Do Your Part"
If you don't believe SRI funds meet your overall needs after considering the whole picture, what are some other ways you can live your values while following your regular investment strategy? Here are a few ideas, some easy and others a tad ambitious:

• Donate a certain amount of your portfolio returns to a specific cause
• Volunteer with an organization that promotes your values
• Call or write individual companies to let them know your concerns as a consumer
• Contact your elected officials regarding issues that matter to you
• Fund a foundation account and use it to support your favored cause
• Become an authority on an issue and look for opportunities to write or speak

Peter Eickelberg is an investment advisor at Keats, Connelly and Associates, a Phoenix-based, fee-only financial planning firm specializing in managing the complexities of accumulated wealth and U.S./Canadian cross border financial planning. He helps research and select the best strategies and investments for clients' cross border and domestic portfolios. For more information, please visit www.keatsconnelly.com.