A Closer Look at Socially Responsible Investing

Summary

Like most professionals, we try to stick to what we think we’re good at. We think we are good at thoroughly evaluating fund managers, and at making extremely well-informed, realistic and dispassionate investment decisions. SRI strikes us not as being about making the best investment decisions foremost, but about relegating performance concerns to a place immediately behind those of social concerns—an area that is well outside our professional expertise. But where we think we can contribute is in laying out the background and goals for SRI, by addressing the various methods used for screening companies, by discussing the unique investment considerations that arise in SRI, by talking about how to evaluate investments within this universe, and by presenting some of the options available to investors who decide they want to go this route.

The Evolution of SRI
SRI is a growing force. The origins of SRI trace back to religious organizations, many of which applied informal “sin” screens, traditionally alcohol, tobacco and gambling. Some groups, such as the Quakers, went further and omitted companies that were involved with weapons and slavery. The movement began in earnest in the 1960s, relating mainly to avoiding participation in the Vietnam War, though its participants were generally regarded as a fringe group. In the 1970s and 80s SRI gained much wider appeal as a way of applying pressure on South Africa to end apartheid by divesting holdings of companies that did business there.

While the specific aims of interest groups have changed over time and will continue to evolve in the future, there are several theoretical objectives that SRI can serve. First, investors can avoid participating in business practices they find unacceptable (principally by not owning the stocks of those companies). Another is to create pressure for social change by raising the cost of capital for firms they view as socially irresponsible. Taken to the extreme, the second tactic could force companies to curtail objectionable business practices so as to gain access to lower-cost capital, and/or avoid negative public opinion that could stem from the activism (consumers’ opinions probably carry far more clout than a small group of potential shareholders in the eyes of most businesses). Conversely, SRI theoretically rewards companies with positive business practices by giving them lower-cost capital. In either case, the effects would probably be difficult to measure. A counterintuitive tactic employed by some proponents of social change is to invest in companies with objectionable practices and work from within to enact change. This is known as “constructive engagement” and was employed effectively to get Shell Oil to reform policies related to its planned abandonment of the Brent Spar oil rig in the mid-1990s and to end its involvement with Nigeria, where a major political party was executing dissenters.

SRI Investments
There are three main ways individuals can use their investing practices to further their social beliefs, depending on their desired level of involvement. One is direct community investment. This does not entail liquid investments in public securities markets, and is probably outside the scope of most individuals’ investment universe (though it can be a highly effective means of enacting change). Shareholder advocacy is another option, where investors seek to foster change by voting proxies and gaining a large enough shareholder base to add items to the proxy that advance their agenda. Finally, and most simply, investors can limit their investment selections to the securities of companies deemed to be operating in a socially responsible fashion, and mutual funds whose portfolios are comprised of the same. The latter is the simplest way for most investors to employ SRI, and the one we will address here.

The use of screens is the primary tool for stock investors to identify companies they seek to avoid. Exclusionary screens are the easiest to employ, and involve setting up clear rules—e.g., no tobacco, no alcohol, etc. These screens seek to divide up the investment universe in a binary fashion between companies that are socially responsible and those that are not. While qualitative work can go into defining the screens, once set up, exclusionary screens are clear and simple.

Qualitative screens don’t use a black-and-white decision variable, but involve a greater degree of subjective assessment of a company’s practices. This can include community relations, the environment, labor practices, and product safety, to name a few. Assessment of these areas can be used as the basis for a rating. The assessment is done using “bellwethers,” since it would not be feasible to examine every single action taken within a corporation. Bellwethers are categories of corporate practices on which verifiable information is available from public and company sources. They allow broader conclusions to be drawn.

Below is a list of qualitative screens employed by KLD (now part of RiskMetrics Group), a leader in SRI research and consulting, for evaluating the bellwether criteria. The process involves assessing each area for both negatives and positives. The firm has specific things they look for, and the strengths and concerns are assigned ratings reflecting their significance. The following examples show how KLD assesses issues relating to diversity and the environment:

Diversity

Strengths

• Board of Directors. Women, minorities, and/or the disabled hold four seats or more (with no double counting) on the board of directors, or one-third or more of the board seats if the board numbers less than 12.
• Family Benefits. The company has outstanding employee benefits or other programs addressing work/family concerns, e.g., childcare, elder care, or flextime.

Concerns

• Controversies. The company has either paid substantial fines or civil penalties as a result of affirmative action controversies, or has otherwise been involved in major controversies related to affirmative action issues.
• Non-Representation. The company has no women on its board of directors or among its senior line managers.

Environment

Strengths

• Pollution Prevention. The company has notably strong pollution prevention programs including both emissions reductions and toxic-use reduction programs.
• Recycling. The company either is a substantial user of recycled materials as raw materials in its manufacturing processes, or a major factor in the recycling industry.

Concerns

• Hazardous Waste. The company’s liabilities for hazardous waste sites exceed $50 million, or the company has recently paid substantial fines or civil penalties for waste management violations.
• Regulatory Problems. The company has recently paid substantial fines or civil penalties for violations of air, water, or other environmental regulations, or it has a pattern of regulatory controversies under the Clean Air Act, Clean Water Act or other major environmental regulations.

SRI Indexes
KLD created and maintains two widely used SRI indexes, one covering 400 mostly larger-cap stocks and the other the broader market. The indexes serve as both a universe of socially screened companies, as well as a benchmark against which to measure investment performance of SRI investment strategies. The Domini 400 (DSI) was formed in 1990. It is comprised of 250 companies from the S&P 500 that passed exclusionary screens for alcohol, tobacco, gambling, military contracting, nuclear power, operations in South Africa, as well as qualitative screens on community, diversity, employee relations, environment, and product safety. An additional 100 larger-cap companies not in the S&P but passing the screens were added, as well as 50 other firms that were chosen on the basis of their “exceptional social characteristics,” rather than size.

The KLD Broad Market Social Index (BMSI) is a socially screened subset of the Russell 3000 that was launched in January 2001. It includes about 2200 companies, all passing the same exclusionary and qualitative screens (see above). Companies whose policies no longer qualify are dropped from the index monthly, and the overall index will be reconstituted to reflect market cap changes, etc. each June.

The Citizens Index is another SRI benchmark. It was created at the end of 1994, and consists of 300 large-cap companies that have been screened for social criteria that include tobacco, alcohol, gambling, weapons, nuclear power, environmental performance, product quality, and employment practices. There is also a Citizens Small Cap Growth Index, consisting of 300 smaller-cap companies.

Investment Impact of SRI
Proponents of SRI argue that the company set resulting from SRI screens makes for an inherently better investment universe, since these companies have less liability risk, happier employees, better public perception, etc. This may be true as it relates to the companies themselves, but investment is about valuation (how much you pay to get earnings) and a larger opportunity set will always yield at least as many opportunities as a subset of itself (by definition). So for a manager, SRI reduces the opportunity set. Taken as a group, it is possible that the subset of socially responsible companies will perform better on a passive basis than a broader set including all companies (though we have seen no convincing evidence of this). But even if it is true, it could be explained by reasons other than corporate practices as they relate to social issues. For example, companies that qualify for SRI indexes tend to have certain characteristics that impact the performance profile.

One observation we have made is that the Domini Social Index is overweighted to financials and technology, and underweighted to energy and utilities. We have also observed this with many—but not all—SR funds. Financial and technology companies have certain inherent characteristics that would probably lead them to score fairly well on SR qualitative criteria. In the case of financial companies, this could be for a couple of reasons: 1) the product they deliver—which is really a service—is not generally considered to be harmful, does not have a major impact on the environment (compared to manufacturers and industrial businesses), and does not involve the exploitation of slave labor overseas. Federal lending and consumer laws also mandate fairness in many cases.

In the case of technology, there are also several inherent qualities that would lead them to score well on screens: 1) in most cases, their “manufacturing process” does not involve very much waste and doesn’t have a big environmental impact 2) many tech companies have younger employees, many of whom are highly educated, in high demand, and are probably more sensitive to gender issues. As such, these companies are probably somewhat more likely to have good gender policies, and 3) these companies import foreign talent to work as programmers, which would give the companies higher diversity scores.

Companies such as utilities (many of which score poorly because of nuclear power facilities) and energy (which have bad pollution/environmental scores) will often be underweighted in SR portfolios. In a universe that is overweighted to technology, the Citizens SRI Index outperformed the S&P 500 by a wide margin, then trailed sharply since valuations began to crash in 2000.

Using SRI in an Investment Strategy
An investor who believes strongly enough in social causes to consider using SRI as part of an investment strategy should do some homework. First, they should check to make sure that the SR investment they are considering actually uses the screens that are important to them. For example, most SR funds screen out companies that are involved in the tobacco industry. Many of them also screen out companies involved in weapons manufacturing and the defense industry. Is that something that you feel passionately about? On the other hand, fewer companies screen for animal testing and human rights, and those may be issues that are important to you. Are women’s rights and employee diversity a key issue for you? Make sure the screens are reflective of your values, or you may end up unwittingly being invested in companies you find objectionable.

Also, it’s worth spending some time evaluating the criteria the SR funds are using to make these determinations. Do they make sense to you? Do they accomplish the goals you think they should be accomplishing?

Beyond the social criteria, investment selections still must be made. Absent convincing performance data to the contrary and given the relatively short time frames involved, we see nothing to indicate that SR investing in and of itself helps or hurts much. It really comes down to the skill of the stock picker. While an SRI universe is moderately smaller, we don’t think that this would preclude a skilled stock-picker from finding the opportunities required to beat an SRI or a non-SRI benchmark. Given the difficulty of consistently beating the benchmarks in the overall fund universe, and given the relatively small number of funds that practice SRI, it is no surprise that there aren’t any clear standouts. Given the lack of any clearly convincing choices among active funds, we think investors wishing to pursue SRI should consider index options as well.

In our research, we base our assessment of a manager on a variety of factors, most related to the team and the investment process. SRI would simply be another data point among many. To date we have not found any managers of socially responsible funds that pass our criteria for doing more in-depth work.

Conclusion
SRI strikes us as a pursuit that probably should not be judged on the basis of investment merit, since its practitioners (at least most of them) have made a deliberate decision to weight social concerns ahead of investment concerns. There may be some who believe that the SRI investment universe is inherently superior, but we cannot see any conclusive evidence that this is the case, so on the basis of their investment merit alone we don’t think investors should favor socially responsible investments. Rather, the decision should stem from their personal beliefs. For those investors who, based on their beliefs, wish to explicitly incorporate their morals or ethics into their investments, the key issues are determining which social criteria are the most important to them and figuring out how to deploy their capital in a way that is consistent with those criteria. While we have not yet found any active SR managers for whom we would pound the table, there are at least a few index fund options that would provide broad-based exposure to SR companies. We also recognize that this is a growing area of interest and plan to continue to look for good options. While we hope that we have provided enough information to frame the important issues, in the end the decision as to whether to pursue socially responsible investing, to make direct cash (or other) contributions to social causes, to volunteer time, or to ignore social causes entirely is one that only an individual can make