December 27, 2016. By Mark Barry:
For many years, there has been increasing interest in Socially Responsible Investing (sometimes referred to as ethical or impact investing) from the investing public as well as institutional investors, particularly endowment and pension funds. Given this, we wanted to provide a brief overview on the topic, as well as provide our perspective.
Socially Responsible Investing (SRI) integrates social and ethical concerns with investment decisions, with the goal to invest in companies whose values align closely with those of the investor. Traditionally, SRI identifies stocks for inclusion in the portfolio through the use of either positive or negative stock screens. Negative SRI screens are the most common, and narrow the investable universe by excluding the stocks of companies in certain industries or which engage in certain types of activities. Positive SRI screens, on the other hand, attempt to identify attractive companies on the basis of criteria considered desirable from a social or ethical perspective.
While investing “responsibly” or “ethically” has a natural appeal in theory, there are many considerations with respect to putting it into practice across a broad portfolio. Namely, what constitutes an unattractive investment from a social perspective? Is it stocks in “sin” industries such as gambling, tobacco, and alcohol? Companies that contribute to carbon emissions, like those in the oil & gas industry? Those linked to controversial issues like abortion or the death penalty? Gun manufacturers and defense companies? Each investor has a distinct set of values, which makes it difficult to create a “socially responsible” investment strategy that works for everyone.
Another challenge is where to draw the line on a company-specific basis. If a strategy is focused on environmental factors, should you exclude General Electric, with its sizable oil and gas services division? But remember, GE also makes wind turbines that generate clean energy. For another strategy, do you exclude Wal-Mart because it sells tobacco and firearms at certain outlets? What about the utility companies that provide electricity to your homes, as they use oil, gas, coal, or nuclear power as inputs? Or companies where issues with executive compensation have been raised, but operate wonderful charitable initiatives like Disney? Deciding what companies to exclude or include in a SRI strategy can become a very slippery slope, and creates an additional set of challenges in portfolio construction.
The impact on performance and portfolio composition from following SRI strategies is another issue. Empirical evidence is mixed as to whether SRI have underperformed non-SRI strategies in the past, but regardless, past performance is not indicative of future performance. Are the benefits of SRI (feeling “good” about your investments) worth the potential costs, if for example one of the sectors you decided to exclude was a strong performer, as is the trend with tobacco stocks? Even if a group of investors is successful in boycotting a stock, there will always be others willing to buy it, possibly at lower prices, happy to reap the gains that you have foregone. In addition to performance concerns, SRI strategies have a tendency to take on a small-cap growth bias, which results in a portfolio tilt that may or may not outperform a more diversified portfolio.
We understand that some investors would be comfortable with a lower rate of return as a tradeoff in order to avoid investing in certain industries or companies. However, we feel that investors should focus on maximizing portfolio returns, and seek to act out their social, ethical, and political concerns in other ways, such as contributing to charities and organizations that align with one’s individual values. Mixing emotions and investing increases the potential for undesirable outcomes. Furthermore, an investor may have a greater positive impact on the causes they care about by creating using a donor advised fund or donating directly; a thoughtful use of portfolio gains.
Despite the shortcomings of SRI, the concept has led to the increased use of Environmental, Social, and Governance (ESG) factors as part of the investment process. Many investment managers have incorporated ESG factors into their decision-making framework, where they compile a list of investable companies through traditional fundamental analysis, and then analyze each company on the basis of ESG factors in order to form a more complete understanding of the company’s future prospects and operational risk profile. Below are some examples of potential factors that come under examination in the process:
- Environmental: environmental stewardship, sustainability initiatives
- Social: employee relations, labor standards, diversity policies
- Governance: corruption, executive compensation, internal controls
In contrast to SRI, the integration of ESG factors into the investment process makes intuitive sense. Overall, a company that scores high with respect to ESG factors is more likely to be well-managed, and well-managed companies are more likely to outperform over the long-run. In addition, analysis of ESG factors may allow companies to identify likely future regulatory or policy directives that would significantly impact their current businesses, and thus make appropriate changes in strategy and/or operations in advance. Such considerations should have a positive impact on some of the issues SRI attempts to address.
Many asset managers have demonstrated their commitment to incorporating ESG factors into their investment processes by signing the Principles for Responsible Investment (PRI), which is an international effort to promote responsible investment. This adoption should continue to gather pace, and in turn it is likely that the investment management profession as a whole will be more closely aligned with some of the values espoused by investors who might otherwise be attracted to SRI strategies. We believe that the integration of ESG factors into the investment process is most certainly additive, and can lead to better outcomes for both investors and the world at large.