Essay: Socially Responsible Investing

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  • Subject area(s): Finance essays
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  • Published on: November 29, 2019
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  • Socially Responsible Investing
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1. Introduction

Wikipedia defines Socially Responsible Investing (SRI) as 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.[11] Simply put Socially Responsible Investing (SRI) is making investment decisions to achieve social and environmental returns without compromising on profitability. As Socially Responsible Investors, while evaluating where to invest their money investors also put social, ethical, environmental and governance concerns in the balance.

Socially responsible investors select and evaluate investments on the basis of both financial and social criteria to make sure that the investments they make are consistent with their value system and beliefs.  Some people are concerned about investing in the companies which are involved in things like alcohol, tobacco, gambling, military weapons, etc. Some are concerned about effects companies have on environment. Some want to ensure the protection of human rights. Usually these investors tend to exclude from their portfolio, companies that are involved in these controversial activities or that do not match their value system. Some socially responsible investors go a step further and choose to invest in companies that show leadership in social issues like companies that pay fair wages to their workers. They use these screening criterions while making investment decisions to make sure that in the process of making money or in the hunt of superior returns they are not supporting or funding socially irresponsible or unethical businesses.  Also as more and more investors use such screening criterions, they raise awareness to firms that are not responsive to social concerns and they can place pressure on those firms to change. [2]

2. Investment Strategies

There are two major investment strategies followed by Socially Responsible investors while investing in capital markets – Negative Screening and Positive investing.

Negative Screening

As part of negative screening strategy, investors screen securities and investments which do not meet certain social and environmental standards. MSCI KLD 400 Social Index popularly known as Domini 400 Social Index is the longest running SRI index which follows negative screening strategy. It was designed to help socially responsible investors to screen publicly traded companies by weighing in social and environmental factors. It is a market cap weighted stock index that provide exposure to US companies that have met certain standards of social and environmental excellence.[12] The index is comprised of 400 stocks majority of which are large cap stocks in the S&P 500. The breakdown of these stocks is as follows:

i) Around  250 companies are large cap stocks in the S&P 500

ii) 100 companies are not in the S&P 500. These provide sector diversification

iii) 50 companies are selected based on their past positive record in social and environmental dealings

Positive investing

Also called impact investing, it is a form of socially responsible investing which aims to bring about positive social and environmental effects while also generating financial gains. Impact investing helps solve social or environmental problems while generating financial returns. [8] While negative screening investment strategy strives to avoid harm, impact investing specifically targets to have a positive social and environmental impact.  Impact investors actively seek to invest in companies and businesses that can provide solutions to social and environmental problems facing the world today. [6]

3. Socially Responsible Investing Portfolio Performance

There is an ongoing decade running for the past two decades that whether sustainable investing gives returns comparable to unrestricted investment.

On the face of it one feels that SRI probably underperforms since it reduces the range of investment and limits investment opportunities.  Opponents of SRI raise similar concerns. They highlight potential negative impact such as increase in volatility and hence increased risk caused by reduced diversification and lower returns due to screening of some high return generating securities.

Morningstar in 1993 reported that socially responsible mutual funds earned approximately 1% less returns annually as compared to the average mutual fund over the period 1988 through 1993. [2] Sally Hamilton, Hoje Jo and Meir Statman in their paper ‘Doing Well While Doing Good? The Investment Performance of Socially Responsible Mutual Funds’ [5] concluded that the returns generated by  socially responsible mutual funds are not much different than the returns on conventional mutual funds.  Jon Entine in his paper ‘The Myth of Social Investing’ [3] questioned the basis of the social ratings generated by social investment researchers like Kinder, Lydenberg, & Domini (KLD) and called these ratings flawed. He concluded that “Social investment advocates rely on sketchy, highly selective research and pseudo-objective ratings that belie the complexity of modern corporations and economies”. [3]

But advocates of SRI claim that it makes more sense to follow sustainable investment strategy to generate superior returns. They list out several advantages which socially responsible firms have over the other firms which make them financially stronger and more profitable.  Socially responsible firms are less likely to face environmental fines; they are less likely to face costly settlements resulting from liability lawsuits for bad quality products; good corporate citizenship may result in increased product sales; and employee loyalty resulting from good employee relationship will help improve productivity, innovation and thus profitability. [2]

Alexander Kempf and Peer Osthoff in their paper “The Effect of Socially Responsible Investing On Portfolio Performance” [1] used SRI ratings of KLD Research and Analytics to form two stock portfolios, one with stocks having high SRI ratings and the other with low SRI ratings. They studied the performance of these portfolios from 1992-2004 and found out that high-rated portfolio generated higher returns as compared to the low-rated portfolio.  They concluded that the studies which compared and proved lower performance of socially responsible mutual funds fail to account for the fact that the performance of mutual funds depend to a large extent on the skills of the mutual fund manager and thus the results of these studies may not reflect the true picture of socially responsible investments.  David A. Sauer in his paper ‘The Impact of Social-Responsibility Screens on Investment Performance’ [2] compared the performance of a socially responsible portfolio with two unrestricted portfolio without taking into account the effects of transaction costs, management fees , etc on portfolio performance to more transparently examine the implications of restricted social investing on portfolio returns. His findings indicated that the social responsible screenings do not necessarily have an adverse impact on investment performance.

4. Impact Investing

While the above studies conclude that socially responsible investments do not underperform as compared to unrestricted investments and therefore should be preferred over unrestricted investment, a bigger question is that can capital markets bring about social change? One way a negative screening investment strategy does help in bringing about social change is by raising awareness about social concerns among socially unresponsive firms. As more and more people turn to SRI they can place pressure on these firms to change and become socially and environmentally responsible.

A more direct way of bringing about a social change is through impact investing. It is a form of socially responsible investing which aims to bring about positive social and environmental effects while also generating financial gains by investing in businesses which work towards bringing about a positive social change. Impact investing helps solve social or environmental problems while generating financial returns. [8] Since the intention here is to generate measureable social or environmental impact, it is distinguished from the negative screens strategy as it explicitly focuses on making a positive impact on the society and environment. This kind of investing is at the intersection of philanthropy and for-profit capitalism. It can act as a complement to philanthropy and government policies to address the social and environmental challenges which we face today at a global level. [6] It is the future of how we should think about businesses because all businesses have a social impact whether good or bad.

Cambridge Associates, a global investment firm, in partnership with Global Impact Investing Network, a non-profit organization dedicated to increasing the scale and effectiveness of impact investing [13], carried out an analysis of the financial performance of impact investing. Post analysis they concluded that the Internal Rate of Return (IRR) of the Impact Investing funds were similar to the IRR’s of comparative funds. [9]

5. Conclusion

Socially Responsible Investing is the future of how we should think about businesses. All businesses have a social impact whether good or bad and through SRI we can steer the investment portfolios away from companies causing negative impact towards the companies which are generating positive impact by working towards a sustainable future. And as many studies have suggested that portfolio returns of SRI funds are comparable to unrestricted investment, there is no reason why one should not follow SRI.  The trends in SRI are positive as more and more investors are moving towards SRI. According to a study by Cerulli Associates, one of six dollars under professional management in the US is involved in socially responsible investing. [11] Though SRI cannot be viewed as a one stop solution to the global sustainability challenges we are facing today but it can certainly act as a complement to philanthropy and government policies to address these challenges.

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