By W. Devin Wolf
Courtesy to the Bellingham Business Journal
These days, socially responsible investing, or SRI for short, is a popular practice among investors who consider themselves socially conscious, and who want to believe their money can do more than just increase the value of their own portfolio. And in theory, this seems like quite the win-win: after all, who wouldn’t want to see their own investments improving the lives of others?
However, as with many things in the world of investing, what you see is not always what you get. Like any other investment practice, moving toward SRI requires great care, research, and a shrewd eye for what is fact and what is a “creative” marketing ploy.
While the complexities of SRI are many, the primary concerns from an investment perspective can be essentially boiled down into three issues:
1. We all have different values and beliefs that guide our thinking about which organizations we are willing to support based on their business practices. This makes it difficult to generalize about how one should approach SRI for themselves.
2. We all have different investment philosophies that we must consider when selecting socially responsible investments. In other words, just because it feels good to support a particular organization for personal or ethical reasons, it might not be a wise choice based on your investment philosophy. This tends to be more of an issue with SRI than with other forms of investing.
3. With the quick (and growing) rise in popularity of socially responsible investments, we have seen an equally sharp uptick in marketing gimmicks that help an investment look more “socially responsible” than it actually is. This means investors must be especially careful to avoid falling for a creatively pitched investment that, when looked at more closely, may be neither as wise nor as ethical as it first seems.
The goal of this article is to demonstrate how I navigate these complexities within my own investment philosophy, which includes advising investors to focus on areas they can control rather than trying to predict the future.
Start with your situation
To build a successful portfolio that includes socially responsible investments, you must first consider your unique situation, including risk tolerance, time horizon, tax profile, and goals. Remember that any successful portfolio must be tailored to the individual doing the investing, regardless of any ethical goals.
Other items within investor control include diversification and fees. Massive diversification is key, as is only paying for services that have a high probability of increasing returns. Here is where SRI can run into problems. It is the very nature of SRI to screen out all stocks that are not deemed socially responsible, which reduces diversification. The screening process itself creates additional work, increasing the cost of the investment. So where is an investor to start?
Approach from a goals-based perspective
Just like any other investment, SRI requires you to carefully examine your goals, and whether or not a certain investment will help you meet those goals. When considering SRI as an option, ask yourself the question, “What do I hope to accomplish with socially responsible investing?”
Many investors making socially responsible selections are hoping to support companies with ethical business practices. On face, this may seem like a compelling reason to pursue SRI over less restrictive forms of investment, even though it may be more complex.
However, it’s easy to forget that when you purchase shares of a company, you are not directly funding that company but rather buying shares from another investor. In this way, choosing to avoid purchasing those shares may not make quite the statement you intend. The exception to this rule is when buying shares at an initial public offering (IPO), where you are buying directly from the company.
Keep things in perspective
If you have a massively diversified portfolio, your positions in each company are likely very small. For example, no single company in my personal portfolio makes up 1% of the overall allocation. Even if you have a one million dollar portfolio which includes a company that you don’t believe makes ethical choices, but that company is only .01% of the portfolio, you really have $100 allocated to this company. At that point, you must ask yourself if divesting that $100 is worth completely rebuilding your portfolio in a manner that may cost you an additional 0.15% ($1,500) annually.
Pick your battles
If you remain certain that SRI will help you sleep at night, you next need to determine what issues are most important to you: the environment, human rights, energy, weapons, alcohol, tobacco, etc. You can then go a step further and identify companies that you do or do not want in your portfolio. There are tools available including mutual fund screeners like social funds.com (note they do not include all SRI funds) that can help you identify funds that share your philosophy. You can review the holdings of each mutual fund at their website to see if they include stocks in the portfolio you would take exception to. Once you have made a short list of funds that seem to share your values, you can start to look at their process and how it aligns with your investment philosophy to aid in determining whether or not it will be a good investment.
Look under the green umbrella
Always look under the hood of the mutual funds on your short list to make sure they are positioning you for financial success. Here are a few steps you can follow to be safe:
Review the expense ratio of the fund, as this has been found to be one of the best predictors of future performance. Lower cost funds tend to perform better over time. Review the number of holdings along with the weighting of various regions, sectors, company size, and valuations to make sure you remain adequately diversified.
Read the summary description of the mutual funds prospectus to learn about their screening process. I prefer SRI funds that use a third party screening service as it helps avoid any conflicts of interest that tend to be present when screening is completed in-house (portfolio managers typically aren’t experts in social responsibility and often their main objective is performance and attracting new assets).
Review performance last. This is often the first item many investors review. I do not believe past performance holds any indication of future performance, but it does provide a truth test as to how the manager has behaved in the past. You can review their performance against their stated processes and beliefs and evaluate why they performed the way they did, if it is consistent with what they say, and if you believe there is a reason this performance will persist in the future. At Financial Plan Inc., we have been constructing SRI portfolios under our current methodology since 2007, and performance has tracked very closely to the non-SRI portfolios. As should be expected, the SRI portfolios over-perform at times, but in the long run have lagged their non-SRI counterparts by an amount roughly equivalent to the additional expenses associated with SRI investing.
The main takeaway for any investor considering SRI is to tread carefully. Viable, green, and thoughtful investments are out there, you just might have to take some extra time (and often expense) to find them.
W. Devin Wolf is a certified financial planner and a wealth manager at the fee-only firm Financial Plan Inc., in Bellingham. He leads the company’s 401(k) branch and serves as chief investment officer, helping families, corporations and foundations make smart financial decisions. Financial Plan Inc. is online at www.financialplaninc.com.