“Socially Responsible” Investing (SRI): History and Trends

The desire to combine personal ethics with investing has been around for centuries.  Religious organizations were the first known adopters, avoiding association with economic activities that were not consistent with their beliefs.  This could be considered an early form of what is described today as “negative screening”: the complete avoidance of investing in an activity that does not meet the ethical criteria, however defined, of a particular investor. 

During the second half of the twentieth century, there were two eras in particular that drove the development of SRI as a broadly acknowledged, if seldom followed, investment approach.  The first was the Vietnam War and social unrest of the 1960’s, which led to a rise of interest in promoting civil rights, women’s rights, and the peace movement.  The second was the human rights and environmental crises of the 1980’s, driven in particular by South African apartheid, and the Exxon Valdez, Bhopal and Chernobyl disasters.  Notions of corporations having social responsibility mandates and of duties to “stakeholders” beyond shareholders came out of these events, and have influenced much of the modern day thinking encompassed by SRI. 

The first socially responsible mutual funds were founded during this era.  In addition to negative screening, these funds attempted to identify companies for investment through “positive screening” methods as a way to promote desired social and environmental behavior.  The table nearby lists the most common screens used by investors today.

Top 10 Mutual Fund Social Screens (Positive and Negative) in 2005

To quantify the potential impact of screening, the market capitalization of tobacco companies in the S&P 500 as of 8/2/06 was 1.61% of the total.

Proponents of SRI argue that companies which are better corporate citizens will earn higher profits through their social responsibility (because they can attract and retain better employees, for example).  This form of SRI, also known as “best in class” investing, commonly involves a scoring system, such as the one used to construct the Domini 400 Social Index.

Today, in addition to the wide use of social screening, institutional investors in particular are turning to activism and advocacy as a way of more directly influencing corporate actions.  Activities range from organized proxy fights to direct dialogue with company management. 

For the individual investor, such activities are not practical on a grand scale, although they can participate, to a limited extent, indirectly through SRI mutual funds.  Individuals often have more success when their efforts are focused on their local communities, either through direct investment or direct philanthropy.

Historical Results

Many studies have been conducted to determine whether socially responsible investing strategies result in superior performance.  So far, there is no compelling evidence that suggests the performance on average is significantly better… or worse… than the performance of the market as a whole.

However, as is the case with any specialized investment strategy, the costs of managing a socially responsible fund is higher than a traditional index fund and, all things being equal, will reduce the returns to investors.  As an example, consider the expense ratio and estimated associated tax costs (as calculated by Morningstar) for two institutional class funds: The Domini Social Equity Fund and an index fund for its related benchmark, The Vanguard S&P 500 Index Fund.

Our Experience
In our years of experience, we have identified four general types of clients with a desire for their investments to reflect their views on social responsibility: the hardliners, the idealists, the pragmatists and the activists.  (These terms are a bit tongue-in-cheek and do not capture the wonderful variety of our clients’ perspectives and desires, and we are not making any value judgments in their use.)  Following is a discussion of each of these four types of investors and what the most appropriate solution is for them in terms of portfolio implementation .

The Hardliners
The Hardliners have a very clear idea about which industries or companies they want to avoid and have zero tolerance for owning these companies.  Hardliners use a series of screens to remove companies from standard benchmarks/asset classes in a binary way (either “in” or “out”).  The resulting screens are often based on a personal definition of social responsibility, rather than any industry standard.

Because these screens are non-standard, the only solution is the establishment of a separately managed account for the asset class(es) involved.  Since “hardline” mandates often screen out companies with market capitalizations that are smaller than the weighted average of the market, the profile of the (market-cap weighted) portfolio is not substantially altered and the performance of the separate account is usually measured against a standard market benchmark.  While there is some additional cost associated with having a separate account (we often use tax-management to aggressively harvest tax losses as a benefit to offset – if not outweigh – those costs), there is no direct additional cost for the screens themselves.  Like other separate accounts, these tend to make sense only for allocations of $750,000 or more.

The Idealists
The Idealists are willing to accept an available (and actually investable) definition of social responsibility, and wish to screen out those companies excluded by that particular definition.  While Idealists recognize that withholding their investment from these firms will not, by itself, impact the financial markets, they hope that the impact of the decisions of all like-minded investors, in aggregate, will motivate more responsible corporate business activity.

There are a growing number of mutual fund and separate account options which screen out companies in a range of industries.  Because the number of companies screened out can be large, the investment profile of the resulting portfolio can be quite different from the market as a whole.  Therefore, the performance of these portfolios is often measured only against socially responsible indexes, such as the Domini 400.

The Pragmatists
The Pragmatists have a general desire to support companies exhibiting social responsibility and good governance, but do not necessarily want to completely screen out any particular company or entire industries.  A “best-in-class” investing approach, as described above, often appeals to them, where their portfolios overweight those companies ranking highest on social responsibility metrics within a given industry.

The best-in-class approach offers significant flexibility in implementation.  Options include separate accounts which overweight companies according to socially responsible criteria, actively managed mutual funds which attempt to add value by owning companies which, they believe, will perform well because they do good, and a new ETF from iShares which optimizes exposure to socially responsible factors.  Some products are measured against standard benchmarks, others against socially responsible benchmarks like the Domini 400.

The Activists
The Activists want to actively support a particular cause.  While public companies may be in a position to help or hinder the cause, activists generally believe that their decision to invest or to withhold an investment in one of these companies is unlikely to cause any direct effect.  They therefore focus instead on donating their wealth and time directly to organizations supporting the cause.  Activists also recognize the poetic justice of using their share of profits from a company to agitate for change in its activities.

Activists do not generally change their investment approach as the result of their interest in supporting a cause.  They have an appetite for profit to support their interests, and invest so as to maximize the return consistent with their risk tolerance.

Our Recommendation
Thus far, at least, the evidence is inconclusive about the investment merits of socially responsible investing and prevailing portfolio theory doesn’t offer much support.  In theory, deviation from market capitalization weighting is expected to produce a lower return over time because the resulting portfolio has a more narrow opportunity set and is therefore less “efficient” (in the terminology of Modern Portfolio Theory).  This conclusion is particularly true where the implementation cost is higher. 

Because of the volatility in financial market returns, definitive empirical evidence (in the form of a statistically significant deviation in performance) is not likely to become available.  The one aspect of future investment performance we can forecast confidently – the impact of high management fees – tilts the scale against the vast majority of currently available vehicles to implement socially responsible investment strategies.  We would therefore counsel clients using SRI vehicles to expect somewhat lower after-tax returns in the long run.

A key element in the Kochis Fitz investment philosophy is the avoidance of cost for unproductive active management.  In our search for the highest after-tax returns for a given level of risk, we are generally not eager to expose our clients to the higher operating and tax cost of SRI alternatives, but, of course, do our best to carefully implement the available approaches when our clients wish to pursue them.  The reality is, despite all of the effort required, SRI screens do not have a major impact on the composition of the aggregate portfolio.  For example, companies characterized as tobacco-related represent only 0.31% of a common Kochis Fitz client portfolio… a mere three dollars for every $1,000 invested. 

Our clients’ experiences suggest that the most effective, and satisfying, approach to SRI is to use the profits from investing activity to support issues and charities directly – the  “activist” approach – rather than by substituting SRI alternatives for our recommended core investments.

Karen Blodgett and Jason Thomas

The authors are pleased to acknowledge the following valuable sources for research for this article:

The Social Responsibility of the Investment Profession, by Judy Hudson, CFA.  Published by the Research Foundation of CFA Institute, 2006.

Socially Responsible Indexes: Composition, Performance and Tracking Errors, by Meir Statman, Santa Clara University.  Published May 2005.

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