Socially Responsible Investing

Here's a piece courtesy of Marotta Asset Management about socially responsible investing. I don't agree with their take on the S&P 500's worth as an investment vehicle (as you know, I like index funds, and the S&P 500 has been a good part of my index investing plan), but I do agree with their thoughts on socially responsible investing (which may surprise some readers.) I'll comment more on this at the end. For now, here's their article:

The oldest socially responsible index is called the Domini Social 400. The index screens stocks it considers inappropriate out of the S&P 500 and then adds favored companies from the Russell 1000. Using the S&P 500 Index or a similar derivative as the backbone of your investment portfolio is a risky strategy that increases the danger of you failing to meet your financial goals.

Socially responsible investing based on deleting stocks from the S&P 500 only amplifies the inherent weaknesses of the S&P 500 as an investment index. Many of the stocks that are deleted from the S&P 500 are value stocks and not growth stocks. As a result, the Domini Social Equity fund (DSEFX) is overweighted towards more expensive (high P/E) growth stocks and has a portfolio beta slightly greater than 1.00. Volatility is greater than that of the S&P 500, which can increase your portfolio risk.

If the S&P were a financial advisor it would say, "Let’s buy mostly large cap growth stocks in the industry that did well last year with a high price per earnings ratio." This advice results in a very aggressive and very volatile portfolio that does better at the end of a bull market than at the beginning. And it will do very poorly at preserving capital during a prolonged bear market - exactly what happened over the last six years.

During the last half of the 1990’s, socially responsible investing could claim its returns beat the S&P 500, but the cause was better attributed to increased risk than to social consciousness. In 2000, when growth fell out of favor and value came back into favor, the Domini Social Equity fund started underperforming the S&P 500 significantly and still has not recovered.

The weaker returns can be attributed in part to the screens eliminating more value stocks. Another drag on returns is the fact that socially responsible investment products typically have higher expense ratios. The Domini Social Equity Fund, for example, has an expense ratio of 1.13% and a 12b-1 fee of 0.25% for a total expense ratio of 1.38%. By comparison, iShares S&P 500 Index Fund (IVV) has an expense ratio of 0.09% and the Vanguard 500 Index Fund (VIIIX) has an expense ratio of just 0.18%.

Often, socially responsible funds fail to meet our investment criteria which include several different factors in addition to expense ratio. In only four of the last twelve quarters has Domini Social Equity scored in the top quartile of large blend funds, and in six quarters they scored in the third quartile according to the Center for Fiduciary Study’s ranking. Its three year average score is 40 on a scale of 0 (perfect) to 100 (worst).

One of the problems with socially responsible funds is that they are not always a financially responsible way to best ensure that you reach your goals. Socially responsible funds rarely use the criteria that an informed investor would use. Most avoid "sin" stocks such as gaming, liquor and cigarettes. Few people dislike cigarettes as much as I do, having lost close family members to cigarette-related illnesses, but even these simple screens are suspect.

Altria Group (MO), formerly Philip Morris, changed its name and its business structure when it purchased Kraft Foods and expanded its business to include product lines in 99% of American households. It is more harmful not to buy a company’s products than it is not to buy their stock, but it seems ludicrous to punish Altria for expanding its business model to include healthier products.

On the other end of the spectrum, last year, Pax World fund (PAXWX) sold its entire position of 375,000 shares of Starbucks Coffee (SBUX) worth $23.4 million just because Starbucks entered into a deal to sell a coffee-based alcoholic beverage. There are much worse sins than putting a little whiskey in your coffee.

If you put so many constraints on your portfolio that you cannot meet your financial responsibilities, then you have taken the speck out of your brother’s eye but failed to notice the log in your own eye. It is impossible to create as well diversified a portfolio using funds that claim to be socially responsible as it is to use the full spectrum of investment options.

While the number of fund’s claiming to be socially responsible has grown, the contradictory natures of their screens have also become apparent. Some funds will only invest in company who support homosexual marriages while other funds shun those exact same companies.

One fund refuses to buy any companies involved in the extraction of natural resources, which has been a top-performing sector over the last few years. Energy, mining, and lumber companies are eliminated entirely in this particular fund’s screens. Even the process of putting together the fund’s annual report would be impossible with that screen. From the electricity for the fund’s computers to the staples that hold the recycled paper pages together, the fund is willing to buy the products of the companies whose stock it refuses to buy.

Nearly every company has positive and negative aspects. Take, for example, Southern Peru Copper Corporation (PCU). Many mining companies are excluded on environmental issues alone. Southern Copper has been working at modernizing its smelting process in order to satisfy the company’s environmental agreement with the Peruvian government. Should an advisor shun investing in those electronic companies that purchase from the most inexpensive source of copper, often the company with the worst environmental process?

Because of its extremely high conductivity, sixty percent of copper is used in electrical and electronic goods. Even if an investor decided not to invest in Southern Peru Copper Corporation, it is unlikely that an advisor or client would go as far as boycotting purchasing the electronics that cause the demand for copper in the first place.

Seeking to use your investment selection in order to be socially responsible is misguided. Though it may assuage a guilty conscience, it is an ineffective tool for corporate change. While it gives the appearance of taking a stand for certain values, it dodges the difficult issues that shareholders bear.

The importance of handling your finances as a responsible steward is usually not best served by utilizing funds claiming social responsibility. While there are companies whose business may best be avoided, delegating that selection criterion to a fund’s screening process is like use a blunt instrument to do brain surgery. Better is having a financial advisor who gets to know you personally and manages your finances according to your specific values.
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There are (generally) two schools of thought when it comes to socially responsible investing:

1. You should not invest in companies who "do harm" (whatever your definition of "harm" is -- it may include beer, cigarette, non-green, non-benefits for same sex partners, etc. -- the definitions vary from person to person.) By not investing in them, you are not supporting them (not giving them your money.)

2. Unless you have really, really, really big bucks, any investment you make in a stock is going to have virtually zero impact on a company (for instance, if you buy 100 shares of Altria, that purchase doesn't impact the company in any meaningful way.) As such, you should invest in whatever companies you like regardless of what they do, then use your profits (which have been maximized using this approach) from investing to give to causes you support that "do good." (Again, however you define "good.")

I use a modified approach, but I'm more on the side of #2 than #1. I don't invest in certain companies that are questionable ethically in my mind (and whose products I would never use), but it's more because they aren't good investments rather than they make "bad" products. Those companies are going to exist and do business whether or not I invest in them, and if they were good investments, I'd put money into them, make a good amount, then use part of the proceeds to help out causes I believe in. I'd see it as "turning bad money into good money."

So, what do you think about this issue?

Comments

[Bill]

Unless you purchase the stock at its IPO, none of your money is supporting the company at all. So, it comes down to if you have an aversion to saying, "I'm a (miniscule) part-owner of this company."

Personally I could care less. I work for a company that would never make the cut in such a fund. I certainly don't care what a company does (within the law) as long as its a good investment.

[John Schneider]

Since I publish a socially responsible business website (Latakia's Socially Responsible Business Forum), I am predictably in favor of socially responsible investing. Putting your money where your values are is important for many investors, as many have seen first hand the effects of irresponsible or unethical corporate behavior.