Good Honest Dollar $$

As mentioned in the previous post in this series, critics of Socially Responsible Investing (SRI) generally fall into three broad categories:

• Those who are opposed to the concept of SRI based on principle;
• Those who believe that SRI compromises investment performance; and
• Those who feel that SRI is not an effective mechanism to produce positive social outcomes.

Today’s discussion deals with the second category. The first category was dealt with in last Friday’s discussion and the third category will be discussed next Friday.

(This post is will not discuss empirical evidence relating to investment performance of SRI funds – this will be dealt with in a later post. The discussion in today’s post relates to the nature of the objection as well as that of counter arguments.) 

 
Different approaches, different outcomes

The question of whether or not investing in a socially responsible fashion compromises financial performance is not a clear cut issue, particularly as there are a number of different approaches toward SRI and expected financial outcomes will vary according to the particular approach which is adopted.

Take Social Venture Capitalists, for example. Whilst some social venture capitalists fund only ventures or projects where the anticipated financial return is commensurate with the (considerable) risks involved, others are prepared to accept a lower rate of return, believing that the anticipated social or environmental benefits from such projects makes their funding worthwhile despite the sacrifice in expected financial return.

Or consider Community Investing. Anticipated returns on investments with Community Investment Institituions vary according to the specific institution and type of investment involved. However, generally speaking, investors are given the option of purchasing investment products which are anticipated to earn competititive rates of return compared to other investments within a similar asset class,  or alternatively purchasing instruments where the anticipated financial return is below that of other investments within a similar asset class. The advantage of the latter option over the former is that it allows for more funds to be invested in the relevant community projects and thus has a greater social impact.

My point here is simply that there are different approaches toward SRI, and anticipated financial performance will vary according to the type of investment involved.  

 
The most common approach – a portfolio of ethical investments

The most common approach to ethical investing is to construct a portfolio of investments which meet certain ethical criteria.

Investors who adopt this approach typically either adopt a negative screening approach, whereby certain exclude certain investments from their portfolio on ethical grounds, and/or a process of applying positive screens – purposeful discrimination in favor of a selective range of socially and environmentally benevolent sectors. 

In the case of negative screens, where such screens are applied too strictly, this process places severe limitations on investment options and hinders the ability of investors to generate competitive investment returns. It also severely limits the ability of the investor to construct a well-diversified portfolio and thereby to effectively manage portfolio risk.

However, if investment screens are applied in a sensible fashion, then the screening process should still allow for a wide range of investor choice, as well as ample freedom to construct a well diversified portfolio.   

On the other hand, the process of applying positive screening may or may not adversely affect investment performance from a financial perspective, depending upon how narrowly or broadly the screening process is applied.

The practice of restricting portfolio investment to a singular sector or a narrow range of sectors may well compromise investment performance. Such a strategy places severe limits in terms of investment choice and flexibility, as well as exposing the portfolio to a high degree of risk and volatility.

However, the positive screening process need not compromise anticipated investment performance to a material extent. Rather than restricting investment options to a narrow range of sectors, portfolios can be constructed which include investments across a broad range of sectors, such as health and well-being, education, science and technology, finance, property and construction, alternative energy, infrastructure and other socially or environmentally benevolent industries.

Provided that a sufficiently broad range of industries or sectors are included in the screening process, the practice of applying positive ethical screens to an investment portfolio should not materially restrict investment options or cause undue portfolio risk.

 
Better managed companies

Some proponents of SRI counter that companies which adhere to sound ethical practices are generally better managed companies, and benefit from more productive relationships with a wide variety of stakeholders.

All other things being equal, proponents say, such companies are in the best position to deliver competitive financial returns over the long term.

Whilst it is certainly not the case that every company which behaves in a socially responsible fashion is necessarily a well managed company, I believe that there is considerable merit in this argument.

 
Conclusion

Whether or not investing in a socially responsible manner compromises financial performance or not will depend entirely on the approach taken by individual investors.

Community Investing will generally not produce competitive financial returns, nor will portfolios where ethical criteria are applied in a manner which is too stringent.

On the other hand, sensibly constructed portfolios should allow for a wide range of investor choice, and should result in a significant compromise in anticipated return on investment.

 
Readers please note:

The author is not a qualified financial planner. Information in this post, or otherwise on this blog is intended for general discussion purposes only and is not in any way intended as specific financial advice. Readers are advised to consult a qualified financial planner before making acting on any information or opinions given on this blog.