Identifying which ventures deserve your hard-earned money is not easy. Potential investors consider many factors when creating their investment portfolio. Besides the return potential of an asset, they also look at the tax implications, risk level, dividends, and more. However, these days, many investors go a step further and factor in the impact of an investment on society. When investors select their investments, they not only evaluate a company’s fundamentals and its future growth potential, but they make sure they focus on socially responsible investing as well. This is because they feel that only companies that make the world a better place deserve their investment money.
Socially responsible investing (SRI) is an investment strategy that, in addition to its financial returns, considers the impact of an investment on the environment and society while steering clear of unethical or predatory business practices. This guide discusses socially responsible investing, its history, benefits, pros and cons, and strategies to put this approach into practice.
Table of Contents
What is Socially Responsible Investing?
Socially responsible investing is an investment strategy that considers financial gain and social good when selecting investments. Also known by the names ethical investing and sustainable investing, SRI seeks to positively change society. SRI is an essential concept to investors and companies that aim to improve the social impact of doing business while maximizing value.
Socially conscious investors often look to invest in companies that provide products and services that positively impact society or the environment and follow responsible and ethical practices. They generally consider companies with a good record on ESG issues – Environmental, Social, and corporate Governance. Many individual investors and investment managers use ESG performance metrics to identify SRI assets to build their SRI-focused portfolio. Others use SRI securities for the diversification of their portfolios.
SRI sometimes refers to screening companies with ESG criteria to decide whether or not they should be included in an investment portfolio. There is a wide variety of SRI investors. They include individual investors, foundations, religious institutions, venture capitalists, banks/credit unions, non-profit organizations, and universities.
In general, socially responsible investing emphasizes companies and practices, and products with a positive social or environmental impact. For example, ones that promote human rights, environmental protection, consumer protection, or gender diversity. Conversely, it avoids putting money into businesses that can hurt society or the environment, such as weapons, tobacco, alcohol, pornography, or gambling.
In recent years, socially responsible investing has been growing in popularity. Today, investors can select from a wide variety of SRI funds and investment vehicles. In addition, a growing number of funds commit to social and environmental impact, and the trend is growing year by year. Therefore, It should not be difficult to find an SRI fund that matches your values and criteria.
According to the US SIF Foundation, total U.S. professionally managed assets using sustainable, responsible, and impact (SRI) strategies reached $17.1 trillion at the end of 2019. This is an increase of about 50% percent from 2016. About one-third of the total of all U.S. professionally managed assets were sustainable investments in 2019.
The essence of socially responsible investing is selecting investments that match your values and beliefs. However, those values are not the same for all investors and will vary from person to person. Socially responsible investing has two main goals – financial performance and social impact. Besides these two goals, socially responsible investors often choose their individual investments to promote specific goals that match their values. Examples of these goals can be a cleaner environment, social justice, consumer rights, or morality.
What is ESG?
Investors looking to make socially responsible investments typically evaluate their investments on three aspects – environmental, social, and governance (ESG).
Environmental – Environmental performance measures how well a company conserves and protects the environment. Important environmental criteria to take into consideration are numerous. Here are the most popular ones: Climate policies, carbon footprint, renewable energy, sustainable products, Reduce – Reuse – Recycle, and waste disposal.
Social – Social evaluation focuses on how a company maintains its relationships with customers, employees, suppliers, and communities at large. Here are some examples of social criteria that SRI investors evaluate: Workforce diversity, data & cybersecurity, employee benefits, company’s mission, safety, and company’s position on social issues.
Corporate governance – The evaluation of a company’s governance measures how well a company creates a system of practices, rules, and regulations that determine how it operates and how it manages all its stakeholders’ interests. Corporate governance reviews board and management policies, composition, and compensation. Good governance often leads to ethical business practices and financial success. Here are some of the criteria evaluated when looking for good governance: Financial transparency, shareholder rights, compensation practices, executive compensation and perks, board and management diversity, and how it resolves conflicts of interest.
In the past, it was common for companies to promote ESG as a public relations tactic and for ESG investors to compromise and accept lower financial returns for socially responsible investments. However, in today’s fast-changing world, a proactive approach to ESG policies is critical for a company’s long-term success. In addition, research shows that there is no financial trade-off when investing in ESG companies.
Morgan Stanley analyzed more than 10,000 ESG-focused funds from 2004 through 2018 in its Sustainable Reality Report. The report concludes that return rates for these funds were similar to investments in non-ESG funds. In addition, the research shows that in uncertain markets, ESG investments have less exposure to risk and volatility than non-ESG investments.
These days, many institutional and individual investors expect companies to demonstrate leadership when it comes to ESG matters. There is a belief that ESG criteria serve a practical purpose, and unethical companies will be left behind because they are seen as a long-term risk.
How Following ESG Criteria Benefits Companies and Investors
Increases Stock Liquidity – As huge amounts of capital have become available to businesses that operate ethically, research and consulting firms like MSCI have created indices that measure ESG criteria and rank companies relative to their competitors. Investors, funds, and ETFs use these indices as benchmarks. Typically, these investors are long-term shareholders who can fuel the demand for the stock.
Unlocks Competitive Value – Businesses that understand the significance of adapting to environmental and social changes can better identify opportunities and meet challenges. Strong ESG policies can provide better competitive value to a company when compared to peers in the industry. Executives who work towards improving labor conditions, giving back to communities, and taking a stand on environmental policies strengthen the business brand. Millennials, in particular, focus on these ESG factors as they become consumers, investors, and employees. Because millennials realize that ESG issues will significantly impact their future lives, they reward companies that adhere to these principles with their loyalty by investing in them.
Helps Attract and Retain the Best Talent – Millennials are serious about working for companies that focus on ethical business practices and social and environmental responsibilities. When employees are loyal and passionate about the company and feel valued, they will likely work harder and become more productive to strengthen the brand.
An extensive and strong ESG program can positively contribute to a corporate brand image, promote sustainable growth, and attract a large amount of capital.
History of Socially Responsible Investing
The origins of socially responsible investing date back to around the 18th century. In the 1700s, the Religious Society of Friends (Quakers) prohibited members from participating in the slave trade. John Wesley, a founder of Methodism, wrote a sermon, ‘The Use of Money,’ that outlined his tenets of social investing and his concept of not making money at the expense of others’ welfare. He urged people to avoid companies in sinful industries, such as toxic chemicals, tobacco, liquor, and guns.
Much later, in the 1960s, another kind of socially responsible investing popped up. During this period of intense social strife, investors started using their money to address labor issues, women’s equality rights, and civil rights. Many corporate governance techniques created during the 1960s are still used today.
Social responsible investing got another notable success in the 1980s when individual and institutional investors began withdrawing their money from South Africa for its racism. Socially responsible investing definitely played a role in bringing an end to apartheid in 1994. Since the late mid-1990s, other issues became the focus of SRI strategies, such as tobacco stocks and climate change. The promotion of environmentally sustainable development really started taking off in the late 90s.
More recently, socially responsible investors started addressing the rights of indigenous people, women, and equal opportunity employment in their investment decisions.
Socially Responsible Investment Strategies
Here are some of the most popular socially responsible investing strategies:
Negative Screening
This investment strategy emphasizes screening for companies that provide products/services and/or practices that negatively impact society or the environment. Investors who follow this strategy will not invest in companies that they believe engage in unethical practices or produces harmful products such as alcohol, tobacco, fossil fuels, and gambling.
Positive Screening
This involves investing in companies that investors think will have a positive social impact. For example, an investor who cares about the environment will typically include investments that focus on renewable energy and sustainability. Another example of positive screening includes investments in companies with policies to provide workers with fair wages, safe working conditions, and equal employment opportunities.
Impact Investing
Impact investing is a socially responsible investing strategy that focuses on investments in companies that intentionally generate a specific measurable, beneficial environmental or social impact in addition to financial gains. Many consider impact investing an extension of philanthropy. Impact investing is mostly conducted by institutional investors, private foundations, financial institutions, and other fund managers. The Gates Foundation is a great example of a foundation that engages in impact investing. Although its primary goals are philanthropic, it also has created a strategic impact investment fund under management. This fund supports organizations and projects that benefit the world’s poorest and are often overlooked by traditional investors.
Themed Investing
This investment approach is also called thematic investing and focuses on predicted long-term trends rather than specific companies or sectors. An example of themed investing would be ESG investing and faith-based investing.
Shareholder Advocacy
As a shareholder of a publicly held company, you are part owner. This means that you have the right to influence its policies. This is called shareholder advocacy. There are several ways to exercise your shareholder advocacy rights. The first one is by proxy voting. This means that you can vote on items presented for a vote at the company’s annual meeting. The second way to influence a company’s policies is through shareholder resolutions. Resolutions are proposals to management about how to run the company.
Any investor with at least $2,000 in stock that has been held for at least 1 year can file a resolution to be voted on by proxy. Resolutions allow investors to raise important social, environmental, and corporate governance concerns. Even if a resolution loses the vote, it can still influence the management team’s decisions to attract enough support. In addition, just filing the resolution can attract media attention, educate the public, and start discussions between the investors and management about the issue at hand.
Between 2018 and 2020, the most often filed resolution was disclosing and managing corporate political spending and lobbying. Other popular topics for resolutions are greenhouse gas emissions and workplace discrimination based on ethnicity and sex.
The third way shareholders can execute their rights as shareholders is by shareholder engagement. Investors with large holdings in a company, such as fund managers, can directly talk to company executives to raise their concerns.
Community Investing
Community investing refers to a type of socially responsible investing where the main focus is on the positive impact on the community rather than the financial return. Instead of buying stocks traded on the stock market, investors can invest directly in community-based organizations to create a bigger social impact. Such investment institutions often provide loans to alleviate poverty and inequality, fund low-income housing, create small businesses, and improve education. They use investor capital to fund loans that regular financial institutions will most likely deny.
Community investing can happen on a local level as well as on an international level.
Types of Socially Responsible Investments
As the interest in SRI has increased significantly, brokerage firms, mutual fund companies, and Robo-advisors are offering a multitude of financial products that follow ESG criteria. There are several types of socially responsible investments. Some of these include:
Mutual funds and ETFs – Many ESG mutual funds and index funds are adhering to ESG criteria. For example, you can find approximately 200 funds that focus on ESG on the website of US SIF, the Forum for Sustainable and Responsible Investment. You can screen the funds by performance and market cap size, and it will show you what screening criteria the fund uses for its investments.
Community Investments – Investors interested in SRI who want to have a greater social impact can also directly invest in projects that benefit community development. For example, you can contribute to community development financial institutions (CDFIs) that provide credit in low-income areas.
Alternative Investments – SRI has also spread to alternative investment vehicles such as hedge funds and property funds such as REITs. As a result, most of these funds have significantly improved their ESG reporting and scoring.
Microfinance – Small loans offered by microfinance companies are another way you can put money to use for a good cause. The money is loaned to poor people, often women, to start a business in various parts of the world. Some of these microfinance companies, such as KIVA, are non-profit, so there is no financial return for you. Others are for-profit, and you will earn a certain percentage in interest.
Advantages of Socially Responsible Investing
Like all types of investing, socially responsible investing has its benefits. Here are some of them.
- Feel good – Socially responsible investing can make you sleep better at night and give you a feeling of accomplishment because you are doing something good for society. With the large selection of SRI funds available, it is pretty easy to find funds that focus on your values. For example, If you feel strongly about global warming, you can pick a fund that focuses on green energy.
- Take a Stand – You can also take a stand with socially responsible investing because you can avoid companies that don’t behave responsibly. As more and more people start investing in socially responsible companies, others will follow the trend. This type of investment means you are taking a stand for change.
- Punish unethical companies – Socially responsible investing rewards ethical companies and punishes those that act unethically. The more people invest in ethical businesses and avoid unethical ones, the more rewards ethical companies see. This could be a catalyst for big social changes. Unethical companies will have to start making better choices to be able to compete with ethical companies.
- Returns are increasing – As socially responsible investing is becoming more popular and the demand for these stocks increases, returns are likely to increase.
Disvantages of Socially Responsible Investing
Besides advantages, socially responsible investing also has its challenges.
- Might distract you from financial goals – When you limit your investment options to companies that only practice social responsibility, you may compromise on your return. As socially responsible investing becomes an objective, it might distract you from your expected financial goals.
- May compromise return potential – Another limitation is that you might not see profitable investments as you focus solely on socially responsible funds and stocks. You might pass an investment opportunity because of its poor social responsibility performance and lose out on its potential. You might also choose not to invest in a company if it is not ethically responsible and miss out on a great opportunity.
- Time consuming – Socially responsible investing can also be time-consuming. The modern business culture puts a marketing spin on everything. With a great SRI marketing campaign, people will believe a company to be socially responsible even when it is not. Just because a business claims to be a sustainable investment option doesn’t mean it actually is. Research is often necessary to prove that a company actually does what it says it does. In addition, the definition of socially responsible investing is quite subjective and there is always a risk associated with this investment strategy
- Lack of diversity – Lack of diversity is another negative of socially responsible investing. Unfortunately, many ESG-focused funds only include large-cap stocks which really limits diversification in investor portfolios.
The Future of Socially Responsible Investing
Socially responsible investments cannot only deliver great financial returns but also create a lasting impact on society. The continuing emphasis on social justice and increasing awareness about environmental concerns have fuelled investments with strong ESG ratings.
As social injustice and income disparity continue to grow, socially responsible investing is gaining momentum. With more investors showing concern about the impact of their investments, companies strive to add sustainability to their financial strength. The future of this investing approach continues influencing markets. Covid-19 and its socio-economic consequences like diversity, income inequality, and climate change will further increase interest in SRI-focused funds.
Sustainable investing expands beyond funds and stocks. Green bonds are fixed-income instruments designed specifically to support specific environmental and climate-related projects. In addition, most green bonds come with tax incentives to make them more attractive to investors. As a result, the number of green bonds has been rising year after year. According to climatebonds.net, $297 billion in green bonds were issued globally.
Conclusion
Socially responsible investing is an investment approach that helps achieve social and environmental goals and financial gain. Implementing SRI is simple and similar to traditional investing. The only difference is that you add extra investment criteria to focus on investment opportunities that positively change society.
Putting your money into socially responsible investments is a win-win strategy. It not only gets you great returns but also promotes values that you consider important. Though the strategy limits your investment options, it will make you feel good while maximizing your returns. Moreover, with such a huge array of socially responsible funds available, building a successful socially responsible investment portfolio is quite easy.
