What Is Socially Responsible Investing?
Craig Donofrio — Break It Down
We’re used to viewing financial success as being at odds with our values, and in the 20th century that view pervaded the stock market as well. Tobacco, weapons, and oil companies were profit juggernauts, and conventional wisdom held that social and environmental solutions were best left to the nonprofit and public sectors. But by the early 2000s, some investors were fed up with strategies that seemed unable to reconcile returns and ethical corporate behavior. As their ranks swelled so did options for so-called socially responsible investing.
These days, it’s estimated that 1 of every 4 dollars is invested according to socially responsible strategies, and the trend seems to be accelerating, spurred by a new generation of investors. “Socially responsible investing is becoming more popular with many demographics, particularly millennials,” says Robert Johnson, president and CEO of The American College of Financial Services in Lincoln, Nebraska. Johnson notes that millennials not only are more socially conscious, but their savings rate is higher than previous generations. He theorizes that the generation’s earning and investment potential “could drive up the prices of these companies and raise returns.”
Indeed, socially responsible investing funds have been consistently meeting the broader market benchmarks, and in 2017, some of these funds jumped ahead of the S&P 500.
If you’ve been thinking about getting started with socially responsible investing, here’s what you need to do know.
What is socially responsible investing?
Often, getting started in socially responsible investing, also known as SRI, means first finding your own moral compass. What might be perfectly fine to you—say a major whiskey manufacturer—might be a deal breaker for another investor. “The definition of socially responsible differs from individual to individual,” says Johnson. “It’s in the eye of the beholder.”
SRI can be about what you don’t invest in, like excluding companies that deal in socially and environmentally detrimental practices like fossil fuels, tobacco, and weapons, or those with poor human rights records. There are also ways to “positively screen” for companies that make commitments to the environmental or social good, and which also tend to exclude unsavory industries or companies.
If this all seems a bit overwhelming, you can relax knowing that there are several third-party firms that measure individual companies’ social responsibility, primarily for investment companies constructing portfolios in that niche.
Funds and indexes tracking social responsibility will often evaluate a company on its environmental, social, and governance impact. While each report provider has its own specific rating scale, they all consider:
Environment: While resource-hungry companies with huge carbon footprints and track records of pollution are clearly not high-scorers, many companies’ environmental impact is more nuanced. For instance, most multinational corporations have large carbon footprints, but some have been proactive about shrinking theirs via renewable energy use and carbon offsets.
To achieve a solid score from social responsibility watchdogs and indexes, companies must publish corporate responsibility reports that confirm such practices. Failing to do so can damage the company’s reputation. Amazon, for example, does a lot of good, yet it refuses to disclose its carbon footprint and as a result has received an F from the Carbon Disclosure Project.
Social: Social issues include diversity and inclusion efforts among personnel, community engagement, upstanding labor standards and human rights records, ethical treatment of employees, and good data privacy protection for customers. For an example of a terrible social environment, see Uber.
Governance: Governance considers corruption, lobbying efforts, political contributions, diversity and inclusion among the board of directors, and executive compensation.
While SRI is a feel-good way of making money, it’s still just that: a way of making money. And just investing in a company that does good for the world doesn’t mean it will do good for your investment account. The ESG bonafides of a particular company or fund, in other words, don’t excuse investors from doing their homework.
Though a few holdouts still pooh-pooh the concept altogether as an investment strategy, “studies have shown that, generally, the returns to socially-responsible investing aren't materially higher or lower than average investment returns,” Johnson says. According to Johnson, the main thing to avoid with SRI is “concentrating investments in a few companies or in a particular industry—in other words, inadequate diversification.”
For example, putting too much money into one SRI-approved industry, like clean energy, can leaving your portfolio vulnerable in the event of a sector downturn. The good news is that you can pick a fund or index that’s both diverse and centered on companies with high ESG scores. The Forum for Sustainable and Responsible Investment has a list of SRI mutual funds evaluated by Bloomberg.
“While investors should not expect higher returns from SRI, they should also not expect to sacrifice returns for feeling good about the companies they invest in,” Johnson says.