You may have seen mutual funds or exchange-traded funds that focus on a very particular trend or thesis.
Many of these got their start in the roaring 1990s. From today’s lens, it was a crazy time: internet connections required dial-up connections, Microsoft Corp. ( MSFT) saved Apple ( AAPL) from bankruptcy, and the United States had a federal budget surplus. The first U.S. ETF, launched by State Street Global Investors to track the S&P 500 index, came to life in 1993. Bizarre strategies such as the StockCar Stocks Index Fund, made up of companies that sponsor NASCAR Winston Cup, came into a brief existence, but over the years its assets under management rarely topped $6 million — a paltry amount for a fund product. The fund was liquidated in 2010.
Nevertheless, niche funds are still around, and still doing their best to lure assets. Some are more successful than others.
The niche that has taken off over the past 20 years and is becoming mainstream is socially responsible investing. SRI is a strategy that seeks to maximize both financial return and social good. It is a way to use investor’s funds to positively impact society.
[See: These 7 Funds Make You Feel Good About Investing.]
SRI allows investors the flexibility to incorporate their values in their portfolio holdings. The demographic groups fueling the growth of responsible investing are mainly millennials and female investors. According to a report by Morgan Stanley, 84 percent of millennials are interested in responsible investing. The same Morgan Stanley report estimated that women control 39 percent of the U.S. investable assets, and are more likely than men to consider responsible investing.
The amount of money invested in SRI has increased to over $6.5 trillion in 2018. That includes huge amounts from institutional investors committed to responsible investing. Last year, Peter Nadosy, chairman of the Ford Foundation’s investment committee, announced that the foundation would commit $1 billion to investments that “earn not only attractive financial returns but concrete social returns as well.”
The first component of SRI investing is screening, or the process of selecting companies based on their social, environmental and governance positioning. The second main component is shareholder activism, which involves using one’s rights as an owner to push companies to make changes based upon socially responsible principles. Common SRI issues include: alcohol, tobacco, gambling, fossil fuels, weapons, child labor, employee discrimination, board diversity and religious doctrines. Some funds focus more on some issues versus others. For example, a fund whose focus is the environment may not screen out alcohol companies. But a fund with religious leanings may want to omit alcohol, tobacco or gambling companies.
So how do these goody two-shoes portfolios match up against unrestrained indexes that track a wide swath of stocks, including all the vice holdings? The biggest underweight in most SRI portfolios is the energy sector. Energy currently represents 6 percent of the market capitalization in the S&P 500, while typical SRI portfolios have a 0.3 percent weighting in energy holdings. Given the underweight in energy, it’s safe to assume that SRI portfolios should outperform passive indexing whenever energy is lagging the broader index.
[See: 7 Socially Responsible ETFs for Investors of All Stripes.]
But what happens when energy is a strong performer again? According to Alex Edmans, a professor of finance at London Business School, “The evidence is clear that investors undervalue socially responsible firms.” A joint study done by Harvard, Stanford and Yale universities showed that firms with stronger shareholder rights tend to outperform their weaker peers when it comes to price appreciation.
Meanwhile, a study from the University of Rotterdam shows that companies with greater eco-efficiency, or the economic value created relative to the waste a company generates, outperform peers with lower eco-efficiency. In addition, a 2015 report from Arabesque Partners and Oxford University reviewed the relationship between corporate sustainability practices and company financial performance. The study indicated a connection between better company sustainability practices and factors including lower cost of capital, better operational performance and better stock price appreciation.
The most common criticism of SRI investing is that it limits the investable universe. According to a white paper published by Morningstar in 2016, portfolios containing stocks from companies that perform well on social responsibility metrics have higher risk-adjusted returns.
Morningstar cited research by Indrani De and Michelle R. Clayman, which showed stocks with the best performance always scored higher on environmental, social and governance (ESG) metrics. In addition, stocks with better ESG strength were less volatile. Since 1990, the socially conscious Morgan Stanley Capital International KLD 400 index ( DSI) of U.S. stocks outperformed the S&P 500 in almost every time frame, and had better returns than the market cap-weighted index in both bull and bear markets.
Research and performance history imply that socially responsible investors receive superior absolute returns and risk-adjusted performance, while also addressing sustainability concerns. Dollars invested in sustainable and socially responsible strategies provide companies with better ESG metrics easier access to capital, which reduces the cost of equity and supports higher stock prices.
[See: 10 Skills the Best Investors Have.]
Although on aggregate SRI funds perform better than unrestrained funds, investors should still consider a fund’s investing style, expenses and fund quality when making a selection. But there is no reason, based on the research and performance, to steer away from sustainability as part of one’s investment portfolio.
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Socially Responsible Investing Delivers for Investors originally appeared on usnews.com
