Is Socially Responsible Investing Really Worth It?
According to Wikipedia, “Socially responsible investing (SRI), also known as sustainable, socially conscious, green, or ethical investing, is any investment strategy which seeks to consider both financial return and social good.” The idea of promoting social good through investment selection has been around for a long time, but gained worldwide prominence as part of the effort to end apartheid in South Africa. From the 1970s to the early 1990s, large institutions curtailed investment in South Africa as a protest against apartheid. The subsequent negative flow of investment eventually forced 75% of South African employers to draft a charter calling for an end to the practice. While the SRI efforts alone did not bring an end to apartheid, they definitely contributed to its demise.
In general, socially responsible investors encourage corporate practices that promote environmental stewardship, consumer protection, human rights, and diversity. They may intentionally avoid businesses involved in alcohol, tobacco, gambling, pornography, weapons, contraception, fossil fuel production, and/or the military, depending on their personal beliefs. The areas of concern are sometimes summarized as environment, social justice, and corporate governance, or ESG. The two questions interested investors need to ask themselves are (1) would I be getting a lower return by switching to SRI investments and (2) would I really be making a difference?
The answer to the first question is muddy at best. Opponents argue that applying ESG factors results in a smaller pool of available funds as compared to those available to the non-SRI investor. The consequent reduced market efficiency leads to lower total returns according to Modern Portfolio Theory (MPT). And if you are an active stock picker, you can’t claim to be socially responsible in your investing if you are only picking companies that you believe will have the best returns. Supporters believe that companies that embrace corporate social responsibility will deliver better financial performance than less ESG-focused competitors. The most authoritative research summary that I’ve found on this topic comes from RBC Global Asset Management, a Canadian investment company. They surveyed studies and analyses that addressed the question from four perspectives: the performance of SRI indices relative to traditional market indices, the performance of SRI mutual funds relative to traditional mutual funds, the relative financial performance of hypothetical SRI stock portfolios against conventional portfolios, and any linkage between corporate social responsibility and improved financial performance. They concluded that SRI investing does not necessarily hurt returns, but the results in my opinion are not especially definitive. Here’s a link to their paper on this subject:
Regarding the effectiveness of SRI on corporate behavior, it depends on how you wield your financial power as an investor. The most common approach is to simply refuse to invest in the “bad” companies. That would potentially hurt them financially by raising their cost of capital, consequently inducing them to reform. The challenge is finding common ground with the definition of “bad.” Is it a company that produces tobacco products? What about weapons? Or is it a good company that makes computers but fails to properly manage the waste generated from obsoleted products? With such a wide divergence of opinion on what constitutes a bad company, coupled with the magnitude of the market capitalization of even small cap companies, it could be quite difficult to collect enough SRI investors to have any significant impact for a particular cause.
An alternative option is not to screen out the bad companies but to screen in the good ones. For example, you could allocate your investment dollars only to companies that show leadership in product design, employee policies, environmental protection, human rights, or other practices. Again, though, it might not be possible to muster enough investors or capital to make enough of a difference.
Another approach is not to divest from the bad companies but rather to take the returns from those investments and use them to benefit your ESG concern or cause more directly. For example, using the earnings from the stock of an environmentally-polluting company to contribute to nonprofits that take care of wildlife after natural or man-made disasters. You can even choose to invest in companies you dislike for the purpose of becoming an activist shareholder, attempting to alter the company’s policies as an “insider.”
SRI investing can be a powerful way to influence company behavior for social good. But there are many ways to approach it, and the effectiveness of your approach should be carefully evaluated. Furthermore it’s not clear whether or not the screening process will cost you in terms of investment returns. It’s important to consider both these things before heading down the SRI path.