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Investment Planning |
Sustainable and Responsible Investing
Recently, a friend asked me about an opportunity to invest her portfolio in "green" investments. My friend lives on the income and earnings her portfolio generates to meet her expenses now and for the next 35 years. I was very concerned about her investing idea.
The "Green" Portfolio Proposition
The idea of a sustainable investing strategy felt good to my friend, and so I helped her look beyond the glossy brochure to view the underlying investments. I've summarized some of the holdings in her proposed "green" portfolio and our concerns about each:
Gold Bullion and Gold Mutual Funds—Investments in gold include mining, which uses pollutants. Mining occurs in countries that exploit workers. Looking at returns, gold outperformed a globally diversified 60% equity, 40% fixed income portfolio only 32% of the time since 1973 (37 years). Gold is extremely volatile and speculation determines its pricing.
High Yield Bonds—Also known as junk bonds, this asset class experienced a huge run-up between late 2008 and 2009, but now valuations are back to reasonable levels. We prefer high-quality fixed income over high yield bonds, as our goal for owning bonds is principal preservation.
Brazilian Real Denominated European Investment Bank Infrastructure Bond, 9.5% Coupon—The stated yield is extremely high in today's investing environment, and this is likely invested in risky assets of the unstable European countries. The high yield suggests my friend's capital may not be protected.
Treasury Inflation Protected Securities ETF - Current Yield 3.8%—Although TIPS and other U.S. bonds are not invested in corporate America, an investment in TIPS helps the U.S. government fight wars.
What Does Sustainable and Responsible Investing Mean?
An investor voting for sustainable and responsible business practices should ask: What's my definition of sustainable and responsible? At least 30% of my friend's proposed portfolio did not have much to do with SRI, even though it was marketed to her as a "green" portfolio. An alternate, and we think better investing style is a diversified portfolio with holdings in thousands of large and small companies around the world. What is more important to you: investing in just a few "green" companies, or many globally diversified holdings?
Investors must consider their portfolio's total cost. Socially conscious investing generally means more investments in growth-oriented companies, such as high tech (which over time tend to underperform value-oriented companies), and higher fees than an index-oriented investment design. A pure SRI portfolio is biased towards growth and small cap, with less exposure to large cap U.S. (such as energy) and international companies. (Large cap international companies are less transparent than their US counterparts.)
We like low-cost, tax-efficient holdings in our client portfolios. This simple strategy ensures an investor receives the returns of the worldwide market, and has a higher chance of reaching long-term financial goals. We can't control the markets, but we can be opportunistic, by strategically rebalancing and optimizing tax consequences. Our clients' portfolios are based on well-researched and rational decisions -- never on predictions.
SRI is About Tastes and Preferences
Companies involved in the manufacture or sale of tobacco, alcohol, and firearms are screened out in most socially responsible funds. Is avoiding these "sin" industries important to you? Are you passionate about avoiding animal testing? What about preserving human rights? Do you want to avoid companies where women are left out upper management and the boardroom? To own an investment portfolio that truly mirrors your values, do your homework to understand the evaluation criteria of your proposed investments.
Beyond the social criteria, you must still make investment selections. Given the difficulty of consistently beating the benchmarks in the overall fund universe, and given the relatively few funds that practice SRI, it is no surprise that no clear standouts emerge. Investors wishing to pursue SRI should consider index options. We have a prudent process to help clients invest a portion of their portfolio with an SRI bias, while staying well diversified in a low-cost and globally diversified solution.
An SRI Solution
We help our clients achieve their long term goals through a prudent and carefully-constructed asset allocation. It is imperative to focus first on designing a reasonable investment solution, and then focus on layering in an SRI bias. You must also understand if your existing assets will allow you to maintain your standard of living in retirement. Then, decide if you can afford to compromise portfolio returns to meet your sustainable or socially-conscious investing goals.
For those investors for whom socially-conscious investing makes sense, and who are willing to forego some of their investment returns to limit their investment universe, we would structure a portfolio that blends growth and small cap with some large cap value that meets certain SRI screens. A sustainability overlay provides exposure to companies that are highly rated for sustainable practices, and reduces or eliminates exposure to companies with low ratings. Investors can then choose from two SRI options.
Socially Conscious Investing
In our firm, socially conscious investing means reduced exposure to companies who fail certain social screens. In keeping with our investment philosophy, the portfolio will have more exposure to small cap and value stocks relative to the market universe. Social screens are used to identify companies engaged in the making or selling of military weapons, alcohol, tobacco, and pharmaceuticals, as well as those involved in gambling, pornography, and human rights violations.
Sustainable Investing
A sustainable investment portfolio favors companies pursuing economic growth and development that meets today's needs without compromising those of future generations. By investing in this portfolio, you provide seed money to thousands of environmentally responsible companies that also boast the best in SRI scores. Our chosen mutual fund manager engages a third-party service provider to research and rate companies for their environmental impact. The screens do not completely exclude non-SR companies, but the goal is to minimize investments in such. Evaluation considerations (i.e., screens) include negative factors such as agricultural and ozone-depleting chemicals, climate change, hazardous waste, regulatory problems, substantial emissions and positive factors such as clean energy, environmental management systems, pollution prevention, and recycling.
Don't Let the SRI Tail Wag the Investment Dog
It's very easy for investors to under-perform the market. According to Dalbar, Inc., the annualized return for the average equity investor for the 20-year period from January 1990 through December 2009 was only 3.2% compared to the 8.2% return of the S&P 500. Inflation averaged 2.7% during the period and ate up most of the average investor's return. Most investors tend to buy high and sell low when they let emotions creep into their investment philosophy. Long-term disciplined investors have historically earned higher returns than those who attempt to time the market.
The goal of your own financial independence should be the highest priority (i.e., take care of yourself first). We prepare comprehensive financial projections to determine if a client is on track to achieve these financial goals. We provide suggestions to increase our clients' wealth, including tax planning, cash flow planning, and financial protection in the event of death, disability, legal claims, or other situations. If excess resources exist, and the client wants to support SR or sustainable companies, we'll assist a client towards this end. For most other clients who have an emotional reason for certain investments (e.g., a goal of social responsibility), we encourage these clients to create a "fun money portfolio" that they self-manage. For most people who are not yet financially independent, the fun money portfolio should be no more than 5% of total investable assets. After carving out a fun-money portfolio, the remainder of the client's investable assets is in a globally diversified, low-cost, tax-managed portfolio.
Conclusion
For my friend, a deeper review of the proposed holdings and her financial goals convinced her to stay with her current globally-diversified investment mix. If you are not convinced you're ready to give up returns to pursue investing with a sustainable or social intent, consider the advice we give to clients: make direct cash or stock contributions to your favorite social causes, volunteer time to local charities, and let your investment portfolio reflect the broad global market. With this strategy, you have the highest chance of achieving your long-term goals. And with your investment success, you can more effectively do good, by directly giving cash or your time to those organizations advancing your philosophical views.
Tips Disclaimer
These tips contain information that may change over time as a result of new tax legislation. Although we make efforts to keep this information current, you should check with your tax advisor before taking action based upon any information contained in these tips.