E*TRADE Capital Management
There’s something to be said for putting your money where your mouth is. With many investors increasingly screening potential investments for social issues, it appears they’re adding their conscience to the mix too.
The market size of sustainable, responsible, and impact investing in the United States has grown as investors try to shape their portfolios to reflect their personal values. Socially responsible investing (SRI) was an estimated $8.72 trillion market in 2016, up 33% since 2014.1 And as it has grown, so have the number of investment vehicles designed to consider both financial return and social good.
Those who are interested in investing in the common good may want to consider SRI when building their portfolios. But as there are characteristics unique to this type of investing, here are some best practices investors may want to consider.
Social screening can be broken down into negative and positive. Negative screening was prevalent when SRI began gaining traction in the 1990s. Typically, investors focused on excluding the so-called sin stocks from their holdings, including those related to alcohol, gambling, tobacco, and weapons.
“Eliminating companies that make or distribute products you find objectionable is fairly easy to accomplish,” says Michael Loewengart, Vice President of Investment Strategy at E*TRADE Financial. “Looking inside a company to evaluate its social practices is much more research-intensive, but it’s certainly possible.”
A complicating factor is that large companies are often quite diversified, so it can be difficult to find corporations that meet all screening criteria. For example, an oil company may actually also be a leader in developing wind technology. But the scope of responsible investing has expanded in recent years, allowing investors to take a page from fund sponsors, many of whom now use data-driven evaluation criteria to identify companies that conform to certain social values.
Evolving toward ESG
Today, the trend in SRI is to own top-performing companies that proactively improve the environment, promote social equality and human rights, and have ethical corporate governance.
Known as environment, social, and governance (ESG) investing, investors use positive screens to actively identify companies with missions and operations that align with their values. Popular factors include:
- Environment—Natural-resource management and pollution control, greenhouse gas emissions and climate impact, waste-management practices, renewable energy use, and environmental reporting and disclosure.
- Social—Workplace diversity and policies, product safety and quality, labor management, community relations, fair-trade practices, and corporate philanthropy.
- Governance—Executive compensation, board policies, shareholder rights, business ethics, and lobbying.
“Identifying their moral mandates and the companies that may fit them is just the first step, though,” Loewengart cautions. “All investors need to evaluate the fundamentals to make sure they are buying solid, profitable companies, and that they understand the broader business risks associated with their investment,” he says.
Applying an ESG framework
The most common way to apply ESG to a portfolio is to choose among a variety of mutual funds and exchange-traded funds (ETFs). Many are intended to function as core portfolio holdings, but there are ESG-focused stock and bond funds in all market capitalizations and styles, as well as a handful of index funds and ETFs.
For example, the MSCI KLD 400 Social Index consists of US companies with high environmental, social, and governance ratings. It excludes sin stocks, as well as firms involved in nuclear power and genetically modified organisms. There are also green funds that invest in alternative energy companies, funds that screen companies based on whether their workforce is unionized, and others that measure how companies advance women in the workplace. Some mutual funds promote social responsibility through shareholder advocacy and by investing in nonprofit community development organizations.
As with any mutual fund, it’s important that investors understand an ESG fund’s fees and any associated risks. Loewengart notes that investors will also want to take the time to verify that the manager’s screening standards are in synch with the social issues they care about.
Gauging past performance
The MSCI KLD 400 Social Index, the oldest SRI index, has posted an annualized return of 10.06% since its inception in May 1994, which compares to 9.87% for the S&P 500 Index during the same period.2
But by restricting the stocks they’re willing to own, SRI investors should know that they may see the short-term performance of their portfolio differ from the returns of the broader market.
The tech bubble in the late 1990s offers a good example. Market observers highlight that technology stocks helped many SRI funds outperform the S&P 500 back then. One reason is that tech stocks typically get high ratings on environmental, diversity, and employee-relations measures. But after the bubble burst, the ensuing rally in energy, industrials, and natural resources left many SRI funds behind because they didn’t own those stocks for environmental reasons. Of course, investors always have to keep in mind that past performance is no indication of future results.
The bottom line
Investors interested in doing well by doing good may have to do some soul searching to reconcile their idealism with the real world of investing, especially when looking to increase portfolio diversification. It’s particularly important to define an investment universe and come up with a strategy reflective of their goals, risk tolerance, and time horizon. For those looking to screen for SRI and ESG principles, potential steps to take include:
- Looking for companies that meet moral mandates by using negative, positive, or restricted screens.
- Evaluating a company’s fundamentals in addition to its ethics, and confirming an SRI mutual fund manager’s criteria are a good match with your values.
- Determining a comfort level with selecting top-performing companies that may not meet all social criteria.
“Socially responsible investing, including the increasingly popular ESG criteria, is a very personal philosophy of investing, and there aren’t always clear-cut answers to what each individual should own,” Loewengart offers. “But the good news is that if you want to take a stand according to your social beliefs, your investments don’t have to suffer for it.”
1. “Report on US Sustainable, Responsible and Impact Investing Trends 2016,” The US SIF Foundation. https://www.ussif.org/files/SIF_Trends_16_Executive_Summary(1).pdf
2. For the 5/31/1994–12/29/2017 period according to https://www.msci.com/documents/10199/904492e6-527e-4d64-9904-c710bf1533c6
The S&P 500 Index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the US stock market.
Socially responsible investment strategies may limit the types and number of investment opportunities available to an ETF and, as a result, may produce returns that underperform or diverge from other funds that do not have an SRI focus or from those of the broad market.
This commentary provided by E*TRADE Capital Management is for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by E*TRADE Capital Management or its affiliates. No information presented constitutes a recommendation by E*TRADE Financial or its affiliates to buy, sell or hold any security, financial product or instrument discussed therein or to engage in any specific investment strategy.
Data and statistics contained in this commentary are obtained from what E*TRADE Capital Management considers to be reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed.
Investing in securities involves risk, including possible loss of principal.
Diversification, asset allocation strategies, automatic investing plans and dollar-cost averaging do not ensure a profit and do not protect against a loss. Investors should consider their financial ability to continue their purchases through periods of low price levels.
Indexes used in this presentation are intended to provide a general measure of the market performance for a particular asset class or type. An Index is an unmanaged portfolio of predetermined securities and does not reflect any initial or ongoing expenses such as brokerage fees, commissions, principal mark-ups, management fees or taxes. The inclusion of any one of these items would reduce the performance shown. It is not possible to invest directly in an index.