Sound Investing 10: Social Responsibility

Previous | Next

Consider socially responsible investing

A broader concept of sound investing

This principle is different from the others because it broadens the idea of “sound investment” to include more than the pursuit of good financial returns. Many investors wish to select investments that will not only meet their personal financial objectives, but also contribute to a better society. They would like the companies in which they are shareholders to be working toward desirable social goals, or at least trying to avoid doing harm.

Not all economists and financial planners like to distinguish between what is profitable and what is good for society, but the economic concept of “externalities” provides a rationale for making the distinction. Economic transactions can have costs and benefits for people who aren’t party to the transaction. Corporations and those who buy their specific products don’t bear the full costs of damaging the environment, or reap the full profits from developing new ideas that spread widely in society. Markets sometimes reward individuals for doing things that have negative externalities (social costs), and sometimes fail to reward individuals for doing things that have positive externalities (social benefits). In theory, socially responsible investors can help correct this by favoring “good” companies over “bad” ones.

The devil, of course, is in the details. How does one go about rating companies by social criteria? In his book With Charity for All: Why Charities Are Failing and a Better Way to Give, Ken Stern shows how hard it is to find out if a charitable organization is actually doing good work. If organizations whose mission is the betterment of society rarely publish adequate data about their effectiveness, one can hardly expect profit-making corporations to provide a fair assessment of their social costs and benefits. One approach to selecting companies is to avoid industries whose products you disapprove of, such as armaments, or fossil fuels, or beef. If your concern goes deeper, including not just the product but the specific environmental or labor practices by which it is produced, you will probably need the guidance of social investment specialists.

Social investment funds

A number of mutual funds now specialize in socially responsible investing, and their assets have been growing rapidly. Today about one out of eight investment dollars flows into this type of investment. A lot of that money comes from large institutional investors like pension funds, whose investment decisions can have a large impact on society.

Socially responsible investing takes several different forms. The most common form is screening securities so as to include in a portfolio only those that meet certain social criteria. Many social investment funds avoid investing in companies associated with tobacco, alcohol, gambling, weapons, or animal testing; and many look for good records on environmental protection, human rights, and employment policies. Secondly, funds often engage in shareholder advocacy by voting their proxies in support of responsible corporate policies, or proposing their own resolutions at shareholder meetings. Finally, a few funds invest in community development in low-income areas where capital is hard to obtain. These funds may operate community development banks, credit unions and loan funds to help finance small businesses, affordable housing and community services. Socially responsible investing may be referred to as SRI, or more recently as ESG, for environmental, social and governance.

A good source of information is the Forum for Sustainable and Responsible Investing at www.socialinvest.org. It reports the investment policies, performance and fees of many different funds.

A financial sacrifice?

Critics of social investing suggest that investors may be sacrificing superior returns by basing their investing decisions on anything but strictly financial considerations. Some investors might be willing to make such a sacrifice, but they may reasonably ask how large a sacrifice, if any, is involved.

Some of the criticism is based on the assumption that investors can get market-beating returns by investing in the highest-performing mutual funds. Investors who limit themselves to the relatively small number of SRI funds may be overlooking most of the best performers. However, this argument may exaggerate the connection between past and future performance, and as a result underestimate how difficult it is to achieve consistently above average results even with conventional funds. In theory, an investor who could always be in the most successful funds would make more money than the social investor, but in practice, most investors who chase performance fail to outperform the market in the long run, and more often underperform it once trading costs and expenses are factored in (see my discussions of expenses and opportunity). It may be more relevant to compare the social funds to the market averages than to the highest performing funds in any given year.

Advocates of index funds argue that most investors do better in the long run by accepting the average return of the market than by paying active managers high fees to try and select superior stocks. From that perspective, SRI funds are financially sound investments only if they can offer broad diversification at low cost. Many social funds are quite selective and have relatively high fees because of the research that has to go into company screening. Although it is easy to screen companies for obvious things like selling cigarettes, it is much harder to evaluate a company’s environmental and human rights record, especially if the company has many different enterprises in many different countries. On the other hand, some funds have tried to emulate index funds by developing as diversified a list of companies as they can, consistent with social screening. Funds that want to hold down their own research costs can obtain such lists from others. Overall, social investing is probably more cost-effective than it used to be, but still a bit costlier than straightforward indexing. While the least expensive index funds have expense ratios under 0.1%, expenses for social funds are usually at least 0.5%, with many over 1.0% or even 2.0%. Performance data tracked by the Forum for Sustainable and Responsible Investing shows most social funds underperforming the S & P 500 over the past ten years, many by several percentage points a year. This is due partly, although probably not entirely, to their expenses.

One of the largest and most cost-effective index funds is Vanguard’s 500 Index Fund Admiral Shares, with an expense ratio of 0.05% and average annual return of 8.52% from 2003 to 2013. Vanguard also offers the FTSE Social Index Fund. It tracks the FTSE4Good index, which screens companies according to such criteria as environmental sustainability, human rights, labor standards, and avoidance of tobacco products and nuclear weapons. With an expense ratio of 0.29% and average annual ten-year return of 6.88%, FTSE Social Index is one of the most cost-effective social funds. Still, $10,000 invested in 2003 would have grown only to $17,860 by 2013, while it would have grown to $20,732 in the 500 Index Fund.

Your bottom line

In the end, the best investment plan is the one that is most appropriate for your particular goals and circumstances. Your financial goals don’t exist in a vacuum, but they connect to your life goals and to all that you care about in your family and your community. Investment income can contribute to the quality of life, but it can also detract from that quality if it comes at the expense of a clean environment or of human rights. Your real “bottom line” is not financial profit, but value however you define it.

Leave a Comment

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: