Each of us runs on our own moral compass when it comes to what we define as “irresponsible” behavior. Socially conscious investors have been wrestling with how to integrate their social and environmental concerns into their investment portfolios for over two decades.
Until 2008, many investment products addressed our social concerns, but usually at the expense of our investment needs. Many investors want the world to be a better place, but not at the expense of their personal financial security. The question then becomes: can a conscious investor create a better world with his or her portfolio without sacrificing any of the returns along the way? This article will address that question by looking under the hood of the current Socially Responsible Investing (SRI) and Sustainable Investment (SI) portfolios that are available to the public.
The Costs of Being Socially Responsible
Utilizing traditional SRI mutual funds to build an entire portfolio is a bit like using a grenade to get rid of a few weeds. Such funds are not able to customize their holdings to your specific social concerns. In other words, companies that you would otherwise be content to own may be excluded, and companies you vehemently dislike may still find their way into the fund. SRI funds offer an acceptable level of diversification, but the current menu consists almost entirely of actively managed (high cost) mutual funds. For investors to make an educated decision about being socially conscious with their portfolio, it would behoove them to know the difference between active and passive investing, and which approach their mutual funds are using. More often than not, the total costs of an actively managed mutual fund, which include the expense ratio, the fund’s internal (invisible) trading costs, and possible loads, reduce the fund’s overall return to the point where passively managed low cost index funds would have been a more profitable choice.[i]
Why not just create a customized stock portfolio of socially conscious companies?
To integrate an investor’s social concerns at a custom level, he would have to build a portfolio of individual stocks. To provide perspective, a portfolio at Abacus uses mostly institutional mutual funds that provide an investor with ownership of more than 10,000 stocks. If an investor considered himself diversified by owning a few dozen large US company stocks, a custom portfolio might suffice. It becomes unrealistic when you seek to own a share of the thousands of small and “undervalued” companies (value stocks) all around the world. Such a strategy has historically provided higher returns than one that owns only big US companies (IBM, GM, Home Depot, McDonald’s, etc). [ii]
Let’s assume that a globally diversified portfolio utilizing institutional index mutual funds continues to outperform the S&P 500 by just 2% annually and earns 9% annually over the next 20 years, while the S&P averages a return of 7%. [iii] If a $200,000 portfolio of individual securities was fortunate enough to keep up with the S&P 500 net of all costs (an unlikely event), you would be leaving almost $350,000 on the table over 20 years. In the same scenario, a $1 million portfolio would produce an extra $1.7 million.
The Screens
Negative Screening
The “socially irresponsible” A-list (according to most SRI mutual funds) includes weapons, nuclear power, tobacco, alcohol, pornography, animal testing, and gambling. Such mutual funds may exclude stocks (negative screening) if significant revenues are generated from any of these. A “bad” stock can be excluded from a mutual fund for its role as a retailer, a wholesaler, an affiliate, an owner, or even an “enabler”. For example, a paper manufacturer can get the boot if significant revenues are derived from cigarette companies that purchase and utilize the paper for the production of cigarettes, a company that’s in the business of making cars can be screened out if it has an ownership stake in a gambling operation, and so on.
Subjective Screening
Mutual funds may also use a more subjective screening process where companies are included or excluded based on their record in human rights, shareholder rights, or the environment, to name a few. A subjective screening requires a great deal of research since there is no black-and-white standard for what passes as good or bad.
Best-in-Class Screening
A third type of screening, known as “best-in-class”, involves a mutual fund owning more of the companies that score well in some areas and less of those that score poorly. In some cases, the worst of the worst can be removed entirely from the fund until they get their act together. This type of screening is less likely to favor a particular sector (energy, utilities, technology, etc.), since companies are judged against their industry peers. In other words, Exxon is judged against Chevron and Oracle is judged against IBM. As a result, the basic tenets of asset allocation and diversification are not violated. There is merely a tilting of the holdings towards the more responsible companies.
Because the three most important predictors of a fund’s performance are its exposure to each industry, the average size of the companies it owns, and how expensive they are relative to their book value, best-in-class screening appears to offer the highest probability of equaling or exceeding the returns of a portfolio with no social screens (more to come on that point). [iv] Meir Statman, the Glenn Klimeck Professor at the Leavey School of Business at Santa Clara University, studied each type of screening and category independently to see if there is a relationship between returns and the type of screening used. [v] He concluded that the screening process with the greatest positive impact on returns came from a best-in-class screening approach, specifically in the areas of community, environment, and employee relations.
Sustainable Investing: Where Passive Investing and Socially Conscious Meet
As defined by Abacus, a Sustainable Investment portfolio has a dual purpose. First, an environmental screening is applied to a portion of the portfolio to incentivize publicly held corporations to reduce their environmental footprint and take proactive steps to conserve resources. The portfolio must also adhere to the academic principles that give an investor the highest possible returns for a given level of risk. Based on the academic studies that exist today, this rules out the use of most actively managed mutual funds regardless of how well intentioned they may be in addressing investors’ social concerns.
Currently, two of the only passively managed, socially screened mutual funds designed to keep up with (or perhaps outperform) non-screened passive funds, and which utilize best-in-class screening, are the DFA U.S. Sustainable Core and DFA International Sustainable Core funds. Already one of the most utilized fund companies among fee-only advisors, DFA became the first to integrate environmental screening into passively managed, low-cost funds that include U.S. and foreign stocks, large and small, and growth and value. The screening process results in a rating based on a company’s energy efficiency, carbon reporting transparency, pollution prevention, recycling program, and more.
Doing Well and Doing Good
Each of the following funds holds a blend of U.S. stocks (large, small, value, and growth). The core difference lies in the screening methodologies employed and management style. DFA’s funds are all passively managed and Calvert’s funds are mostly actively managed.
While it’s too early to set an expectation that the movement towards environmentally conscious living will translate to higher returns for companies that respond more fully to this demand, the evidence shows thus far that it’s possible to integrate the best elements of the socially conscious investment universe into a low-cost, passively managed portfolio while maintaining the spirit of Modern Portfolio Theory.
In order to decide between a portfolio that is in line with your “belief systems” (SRI) and one that addresses the needs of the planet as a whole (SI), imagine how you might respond to the following hypothetical question: Are you willing to own $5 worth of tobacco stocks in order to earn an extra $5,000 that could be donated to a non-profit that educates children about the dangers of smoking? If your answer is no, you will require some extra customization with your socially screened portfolio, and you will pay higher costs in order to achieve it. If your answer is yes, than a passively managed, environmentally screened portfolio that utilizes DFA’s sustainable core funds is the first step towards “doing well and doing good” with your investments.
[i]S&P Indices Versus Active Funds Scorecard, August 20, 2009
[ii]Size and Value Effects, DFA, 2010
[iii]http://www.abacuswealth.com/resources/firmoverview.pdf
[iv]http://www.abacuswealth.com/resources/firmoverview.pdf
[v]The Wages of Social Responsibility; Meir Statman, 2/21/08
