Socially Responsible Investing By: Gabriel PotterMBA, AIFA® 2018.05.14

The basics of Social Responsible Investing

Some of our readers will be familiar with the basics of socially responsible investing (SRI).  However, as SRI becomes more popular for both individuals and institutions, the additional assets and increased experience have enhanced the sophistication with which an SRI strategy can be applied. 

Before we discuss the new elements of SRI, let’s review the basics.  Socially responsible investing is the practice of investing in companies, typically through common stock, which promote social good while avoiding those companies which promote social ills.  SRI can go by other names and there are truly distinct variants – values based investing, sustainable investing, responsible investing, impact investing, ethical investing – but the basic idea is the same:  promote social good through your investment selections.

So, what is a “social good”?  That depends on which criteria you use.  The most commonly applied criteria follow ESG - environmental, social, and governance - factors.  Environmental factors are pretty straightforward; avoid companies which pollute the environment and promote companies which seek to limit environmental impact.  Common companies which are excluded from SRI strategies due to environmental factor deficiencies include fossil fuel energy companies.  Social factors consider the relationships the company keeps with people including its labor force, customers, and community. Companies which have been excluded from SRI strategies due to social factor deficiencies include national fast food restaurants, due to disputes over labor practices.  Governance factors depend on the company’s leadership attributes including management oversight, conflicts of interest, transparency for stock holders, collusion with competitors, and adherence to the letter and spirit of the law.   Companies with governance factor deficiencies include firms where the oversight by the (ideally independent) board of directors is corrupted because of current C-Suite executives acting on the very same board.

Applying SRI principles into a real-world investment

Imagine a fictitious investment management company – Greenway Investment Managers.  Greenway is creating a new socially responsible investment mutual fund.  This new mutual fund is a broad US stock market fund which should generally move in the same direction as the market, so as not to surprise their investors.  Thus, Greenway plans to include a wide swath of investments to roughly reflect the economy as a whole.  Greenway’s new fund does not passively follow any particular index, nor a purely market-based index (like the Russell 1000) or SRI-based index (such as Calvert or MSCI’s SRI indices).  So, how does Greenway apply SRI principles to their fund?    

Greenway’s first decision is to determine which companies they exclude from the mutual fund. Greenway simply won’t invest in companies whose primary business includes fossil fuels, weapons, or tobacco.  This is an exclusion strategy.  It’s effective and clear strategy, but they can’t apply it too strictly or they’ll end up with “holes” in their mutual fund. Already the energy, industrials, and consumer discretionary sectors in the fund are becoming less representative of the US stock market as a whole. 

Consider, almost no companies are perfectly good or perfectly bad, no matter which criteria you use. For instance, how might Greenway evaluate a company like Boeing?  Yes, Boeing designs military aircraft, but they are also a backbone of the US passenger fleet, a key part of the economy they’d like to reflect in their new mutual fund.  Moreover, how can Greenway determine how attractive Boeing becomes if the proportion of their business which serves the military changes over time?  You can add to the complexity by considering other factors – like environmental.  For example, imagine Boeing starts massive investment in green-energy jet-fuel alternatives while their competitors continue to rely on engines utilizing fossil-based jet-fuel?  Is Boeing more attractive than an aircraft producer which does not create military equipment, but does have a high environmental impact.

To apply these factors in a consistent way, Greenway implements a quantifiable, numeric ranking system on the ESG factors they consider.  Companies are researched and scored based their adherence to ESG criteria and these ESG scores change over time.  The Greenway mutual fund can then overweight companies with high ESG scores and underweight shirkers. 

Greenway now has the ability to manage an SRI fund with a broad mandate, but their management team wonders how well they are supporting their implicit goal of improving the world through investment in companies – some good, some not as good.  How can Greenway do more?

Suppose Greenway is considering a (fictitious) company for inclusion in their fund – CleanStar Energy.  CleanStar is a solar-panel installer & manufacturer with excellent environmental impact scores, stellar social factor scores and an exceptionally good investment outlook.  However, CleanStar doesn’t have a perfect score due to governance factor deficiencies.  The young company’s CEO and founder also sits on CleanStar’s board of directors.  While this is a clear misstep on the goal towards ideal governance, it is also a very common violation which can be corrected.  Greenway management does invest in CleanStar Energy, but not merely as a passive investor.  Instead, Greenway adopts an activist strategy.  As a partial owner of CleanStar, it can advocate changes and vote (in proportion to its ownership stake) in CleanStar’s management structure.  Greenway does not merely reward good behavior with dollars, but proactively advances positive change in the companies it owns. 

Real world SRI investment vehicles, like the fictitious Greenway mutual fund, apply combinations of these methods – exclusion, ranking, and activism – to apply SRI principles into their products.

Modern themes in Socially Responsible Investing


A generation ago, socially responsible investing was a footnote, but it has grown rapidly in the past decade.  Recent estimates from the US SIF Foundation suggest one out of every five dollars under professional management in the US – trillions of dollars – is invested according to SRI principles.  As the assets under management expand, there is space for additional diversification.  One modern theme is the proliferation of new criteria.  Different SRI funds utilize different criteria.  For instance, some SRI funds omit alcohol stocks while others allow alcohol.  Some alternative energy funds allow for nuclear energy, while others focus solely on wind and solar. 

Also, ESG criteria, while venerable, are only some of the factors which investors acknowledge.  For instance, Catholic-values oriented funds may omit companies whose primary business lines includes contraception or gambling.  Islamic funds restrict alcohol, financial stocks (collecting interest is taboo), and pork.  Investors can find fine-tuned religiously oriented funds which tailor investments for smaller denominations including Presbyterians or Mennonites.

SRI as a strategy

Until recently, socially responsible investing was considered a compromise.  Investors can promote social good, but they are “leaving money on the table” by avoiding potentially profitable businesses.  Recent outperformance of socially responsible companies is causing investors to rethink this notion.  Here’s the argument:  in the short-term, a polluting, exploitative, and corrupt company may generate profits, but is it equally likely to outperform conscientious peers over the long term?  Mightn’t the odds for long term success be better for companies with beneficial business practices?  There are purely mercenary investors – utterly disinterested in social good – who view SRI investments as a viable strategy.  Perhaps they feel bad actors in corporate America will have to adopt better business practices through some combination of regulation, legal pressure, and conforming to public attitudes.  Even when accepting pure profit as the only meaningful criterion, investors might argue companies with socially constructive policies are most likely to adapt and thrive in the long-term.

SRI as an attribute, not a category

Following the principles of socially responsibility used to be a key differentiation of investment products.  If an investment manager, like Greenway, had an SRI product, it was grouped into a separate category with SRI peers by national investment research firms, like Morningstar.  Investment consultants searching for candidate investments for a lineup would have to explicitly select the SRI category to screen for potential candidates.  Further, this SRI category itself was problematic.  Greenway’s fund follows the US stock market, but SRI category peers include US small-cap, developed market, and emerging market funds as well; these funds will behave very differently despite their SRI strategy adoption. 

This situation has improved.  Within the past year, as SRI has become a more popular and diverse, the SRI category has been disbanded and SRI principles are now regarded as an attribute.  This change implies three things.  First, SRI products can be evaluated against more applicable indices and peers; it doesn’t make sense for an SRI emerging market fund performance to be compared to an SRI US large cap fund.  So, the Greenway fund’s return record may directly compete with traditional non-SRI products.  Adherence to SRI strategies no longer appears to be an excessive handicap to performance.

Second, screening by categories is much improved.  SRI products are being compared against non-SRI peers.  Investment consultants will see SRI and non-SRI peers in the same appropriate category, but they may also screen for candidates exclusively using SRI principles if they so choose.

Third, adoption and inclusion of SRI strategies in an investment product does not necessitate reclassification.  For a real-life example, American Century is an investment management company which owes its origin to managing money for a medical institution.  Thus, American Century products have always avoided certain industries stocks which negatively affect health (tobacco) in their funds.  Since American Century products already had elements of SRI investment in their process, it has been simple for them to more fully adopt SRI principles within some products.  Specifically, the American Century Fundamental Equity fund recently incorporated more ESG factors into their exclusionary criteria and changed its name to American Century Sustainable Equity.  However, this expansion of SRI principles didn’t mean the mutual fund had to change categories.  The fund is still a US Large Cap Core product to be evaluated based upon its financial merits, even though it has added another element to its investment selection process.

One last warning for fiduciaries

Many of our readers are fiduciaries.  Fiduciaries have a legal and ethical duty to act in the best interest of those whose assets they control.  A SRI goal does not supersede this fiduciary rule.  Social impact may be a secondary concern to an investment lineup, but it does not surpass financial goals.  Individual investors and charities may allocate their own assets toward impact investing (prioritizing social change over financial returns) or even philanthropic investing, but these investments may be incompatible with fiduciary precepts.

Let’s consider an example.  Imagine you are a senior manager, working for a charitable organization associated with the Catholic Church.  You help decide which charitable activities will be supported each year.  This year, the charity’s funds are allocated – purely philanthropically – to a local homeless shelter. That is perfectly compatible with the charity’s stated goal; no problems there.  In contrast, as senior manager, you also monitor your organization’s defined contribution plan for the employees who work at the charity.  As a fiduciary monitoring the investment lineup available for employees, you cannot create a slush-fund to collect money for the very same homeless shelter in the investment menu.  That action may represent a breach of fiduciary duty since it would prioritize the interests of the local shelter over the interests of your employees, and your first duty of loyalty is to your employees.  Of course, individual employees can give as much as they want of their personal money to the homeless shelter.

Moreover, as a Catholic organization, there are guidelines for investments set out by the United States Conference of Catholic Bishops (USCCB).  These guidelines can be followed, but they must be tempered with analysis demonstrating the investments still meet an independent screening process which demonstrates priority to the true intended beneficiaries.  In summary, no matter how much the SRI goals of an investment coincide with your institutional goals, SRI goals never outpace fiduciary responsibility.  





Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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