Published June 12, 2012
Once regarded as something of a fringe strategy, socially responsible investing, or SRI, has grown respectable. The movement has brought a sense of purpose or higher calling to the investing table, along with the results that matter to investors -- strong, solid returns.
Naysayers have charged that limiting portfolio diversity would automatically lead to poor returns. As it turns out, so-called environmental, social and governance, or ESG, screens often lead to better portfolio performance than conventional investment-picking strategies alone.
The investment-picking process is essentially identical to conventional managers, but there is an extra step. After the usual quantitative process of researching a company's financial profile, there will be a qualitative analysis.
"This is where the social, environment and governance factors come into play. It helps us identify companies that are better managed," says Steven J. Schueth, president of First Affirmative Financial Network, specializing in socially responsible, transformative investing and based in Boulder, Colo.
Those three broad categories -- environmental, social and governance -- form the basis for much of the criteria that managers use if they promote socially responsible investing.
The strategy has changed since the 1920s when socially responsible investing mainly meant avoiding "sin stocks," or companies peddling vices such as alcohol, gambling and tobacco.
"Then it evolved into avoiding egregious polluters. And in the early '80s, it was avoiding companies that were involved in South Africa," Schueth says.
Over the past 20 years, socially responsible investing has evolved. In fact, the acronym SRI doesn't necessarily mean socially responsible investing anymore. "When I say SRI, the acronym is, for me, sustainable, responsible and impact investing. It's about investing to do more than just make money," he says. "We want to make money, but we also want to have a positive impact on the world as we're making money."
While the field's name is still in flux, the acronym ESG is very efficient as it describes some of the screens that fund or portfolio managers apply to pick good investments, but SRI is widely used as well.
"We put our screens or criteria into five general areas. One is environment. The second is workplace practices, which include diversity, labor management relationships. The third is corporate governance, fourth is community impact, and the fifth is product safety and integrity," says Julie Gorte, senior vice president for sustainable investing at Pax World Management in Portsmouth, N.H.
In the old days of sustainable and responsible investing, the screens used were mostly negative, meaning asset managers would mainly exclude investments with them. Rather than cutting out companies, today's screens are largely proactive.
"We're looking for value, which is pretty much exactly what we do when we do the financial analysis of the company," Gorte says.
Some criteria are easier to fulfill than others. For instance, mutual fund investors interested in avoiding all companies that conduct tests on animals will have a tough time in the U.S. There are funds that avoid animal testing in other countries, such as the Henderson Global Care Growth Fund in the United Kingdom, which avoids investing in companies that produce slaughterhouse products as well as those that conduct animal testing.
American fund companies with an SRI orientation typically look for company policies that try to minimize animal suffering.
"We don't necessarily avoid companies that are required to test on animals. That would be pharmaceuticals and also medical devices. But we do want them to have criteria that will minimize the number of animals used, trying to use in vitro rather than the actual animals or the suffering of the animal test subjects," Gorte says.
There also can be areas where innovative leadership is scarce such as energy and oil. Energy companies are huge drivers of returns in conventional portfolios, but oil companies engage in opaque business practices and can cause devastating environmental disasters such as the Deepwater Horizon oil spill in 2010. That's a conundrum for concerned investors who just want to be able to retire someday. But there are options for SRI funds and individuals.
"You definitely have to be more discerning. They're in a very dangerous business. There are physical risks and geopolitical risks and explosive risks. Can we find companies to invest in there? Absolutely, yes," Gorte says.
The intangible rewards of being a do-gooder are a priority for SRI-oriented managers, but returns are equally so. Recent research has found that investing in companies with solid ratings in environmental, social and governance areas actually can be as good as or better for your bottom line than conventional investing.
"The vast majority of literature shows one of two things: one, that those funds perform comparably to non-ESG funds. The other is that they outperform. There are a tiny number of studies that show underperformance," Gorte says.
Jon Quigley, a managing partner and investment manager at Advanced Investment Partners in Safety Harbor, Fla., conducted a study into the extent to which ESG criteria limit portfolio diversity and returns.
First, they eliminated 6% to 8% of the Standard & Poor's 500 index from their investment portfolio by restricting companies that derived more than 5% of their revenue from alcohol and gaming, and from military and defense, or companies that did business with Sudan, a country known for acts of genocide.
Next, they used a data provider that ranks companies on environmental, social and governance criteria to further refine their portfolio.
"We restricted investments in companies that scored in the bottom 20% by their ESG rating, and we found that eliminated 6% to 8% of the S&P 500. If you combine the two, you'd eliminate about 10% to 12% because there are some overlaps in those restrictions," Quigley says.
The end result left 450 stocks.
It turned out that simply by applying the ESG criteria, the investment portfolio saw a little bit of outperformance.
That's not always the case. For example, investors interested in avoiding tobacco stocks can miss out on some unique circumstances in which those particular stocks do well.
"If you look at the fall or late summer of 2011, investors became very risk-averse, and a group of stocks, like tobacco stocks, that pay a very high dividend yield outperformed the market. If you had restricted investments in those companies, you would have underperformed the S&P 500," Quigley says.
For many investors, making the world a better place is not on the agenda when searching for investments. But maybe it should be.
Companies governed in a more socially responsible manner than competitors tend to be more profitable.
"Typically, you would see 20% to 30% less volatility for companies that rate strongly along the environment, social and governance lines versus those that score poorly," Quigley says.
Less volatility means fewer lawsuits and fewer front-page scandals or disasters. That can only be good for investors.