The prominence of socially responsible investing (SRI), which incorporates environmental and social issues into investment analysis and decision-making, has expanded significantly over the past two years. Between 2012 and 2014, SRI assets under management (AUM) in the U.S. expanded from $3.74 trillion to $6.57 trillion, respectively, an increase of 76 percent.1
Over time, advances in research and technology have enhanced our ability to collect data on companies, broadening the scope of many SRI strategies. It is increasingly easy to reflect your values in your investments without sacrificing the underlying investment approach. These are very exciting times indeed. But before you determine whether SRI is right for you, let’s revisit a few fundamental investing principles, which are important whether you engage in SRI or not.
The first principle is diversification. You’ve probably heard of the phrase, “Don’t put all your eggs in one basket”. This may be a cliché, but it holds true for long-term investors. Volatility exists, and no one has a crystal ball to identify every upturn and downturn in the market. Diversification involves spreading your money across various financial instruments, industries and other categories to help limit your losses and reduce risk. Essentially, you are investing in various securities that behave differently under the same economic conditions.
For example, falling oil prices may have a negative impact on energy producers.
But companies that depend on oil and gas to produce and transport their goods may benefit from a drop in oil prices. In this example, your portfolio would likely take a significant hit if you were only invested in energy companies. But if you diversified your portfolio across multiple asset categories, the risk would be reduced.
The second principle is asset allocation. For the typical investor, asset allocation is a mix of stocks and bonds (e.g., 60% equity and 40% fixed income). Asset allocation aims to optimize the reward you will receive for a given amount of risk. In other words, it takes the guessing out of the game, allowing you to own many asset classes proportional to your goals, risk tolerance, time horizon and other factors. To achieve long-term success, the level of volatility must not be more than you can endure so you can stick to your strategy.
Assess Your Portfolio
Now that you’ve laid the foundation of your portfolio with diversification and asset allocation, you can evaluate whether SRI will fit into your overall investment plan. First, let’s break down the mix of investments in your portfolio — this may include U.S. large-cap equity, U.S. small-cap equity, international-developed equity, emerging-markets equity, core fixed income, high-yield fixed income, international-developed fixed income and emerging-markets debt. Does it make sense to employ SRI throughout your portfolio, in all areas of equity and fixed income?
It really depends on your personal values and principles.
SRI means different things to different people. You have to narrow down what social values and concerns are important to you. To help you evaluate this, consider meeting with your financial advisor to complete some type of social questionnaire that will help you identify which values are most important to you to reflect in your investments. For example, let’s say that you are concerned with human rights issues and may opt to exclude companies that are implicated in human rights violations, or support certain governments that have a harmful impact on local communities.2
Some emerging economies have not matured enough to produce reliable data to convey that information, so it may not be possible to employ SRI in such a market. Depending on your values, you may only be able to employ this type of strategy in a particular part of your portfolio.
Now that you’ve explored your values and determined that you’d like to pursue SRI in your portfolio, what other factors should you consider?
Mutual Funds or Separate Money Managers
Mutual funds and separate money managers have different minimum investment requirements, which we’ll discuss in a moment. If your account doesn’t meet the minimum of a separate money manager, a mutual fund will provide you with the diversification you need in that particular space. However, each mutual fund has its own investment strategy, which is disclosed in its prospectus. You do not have control over what is in the portfolio. For example, a mutual fund can exclude companies that exceed its thresholds in certain areas, such as alcohol, tobacco, gambling, firearms, military weapons and nuclear weapons. If you are uncomfortable investing in all of these industries with the exception of alcohol, the alcohol exclusion is the price you will pay to get your other desired exclusions. By investing with a separate money manager, you may be able to have a more custom portfolio that reflects your specific values and concerns.
Minimum Investment Requirement
As I mentioned above, both mutual funds and separate money managers have minimum investment requirements. The minimum for mutual funds can be as low as $2,500 (or have no minimum), while the minimum for separate money managers can be much higher, ranging from $500,000 to $1,000,000. When deciding which option is right for you, it’s important to take these amounts into consideration.
There is no such thing as a free lunch; every mutual fund has an internal expense ratio. Keeping this expense ratio low is important, because the return you will see from this investment is net of these fees. Separate money managers also charge fees. Adding in social screens may result in a higher fee to cover the costs of the extra research required to implement an SRI strategy.
Benchmark and Tracking Error
A benchmark is an index that your SRI account will be measured against. For instance, if the benchmark is the Russell 1000, this means that your SRI account will hold large U.S. companies with specified social screens layered on top. The more screens and restrictions you have, the higher the tracking error will be. The higher the tracking error, the more that portion of your portfolio will deviate from its benchmark.
Negative vs. Positive Screening
Negative screening involves the exclusion of companies based on a threshold.
For example, a portfolio can exclude all companies that generate one percent or more of their revenue from the sale of alcohol. Positive screening, on the other hand, is a proactive process that assigns points to companies whose practices align with your values. More points mean a higher weighting in your portfolio. For example, if you are concerned with employment equality, more points may be assigned to companies that offer consistent benefits to all employees, regardless of gender, race or sexual orientation. Funds and managers may employ one or both of these approaches in an SRI strategy.
Most people are emotional when it comes to handling their own money. After all, it is their hard-earned savings. This is even more true when it comes to values-based investing. If you are passionate about a social issue, those feelings may cloud your judgment when investing. Additionally, you may not have the resources, time or interest to conduct the required due diligence and research potential funds and managers. Therefore, it is important to have an advisor assist you with this process. Your advisor can help you articulate your values and objectively evaluate how practical it is to incorporate those values into your portfolio.