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Socially responsible investing, or SRI, is an investing strategy that aims to help foster positive social and environmental outcomes while also generating positive returns. While this is a worth goal in theory, there is some confusion surrounding SRI is and how to build an SRI portfolio.
What Is Socially Responsible Investing?
Socially responsible investing is the practice of investing for both social betterment and financial returns. This looks like either choosing investments that align with your values or avoiding investments that don’t.
These different approaches can be broadly categorized as negative screening and positive screening. With the former, investors avoid owing securities sold by companies that are seen as not socially beneficial. With the former, investors actively choose to support companies that implement positive social and environmental policies.
“Negative screening could entail excluding companies involved in weapons, defense, tobacco or fossil fuel extraction and production, for example,” says Brian Presti, a chartered SRI counselor and director of portfolio strategy at The Colony Group.
On the other hand, positive screening may seek out companies whose products or services contribute to decarbonization, financial inclusion or health and nutrition.
“In both approaches, investment decisions are governed by values and societal impact considerations,” says Presti.
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How Is SRI Different from ESG?
ESG investing—another acronym that stands for “environmental, social and governance”—is sometimes used interchangeably with SRI. However, the terms refer to two separate practices.
“The primary difference is that ESG investing often uses more of a financial materiality lens rather than a specific values-based one in security selection,” Presti says.
At its core, ESG is a risk-mitigation strategy. ESG investors consider the material risks to a company’s future performance due to its environmental, social and governance practices.
A company that doesn’t treat its employees well may lead to a workers’ strike. A company with poor waste management practices could get fined or face government regulation.
“Combining ESG research with traditional financial considerations can give a more holistic view of an investment and help identify risks and opportunities of that investment,” says Carey Burke, ESG/sustainability product lead at Hartford Funds.
“Integrating ESG factors into the investment process does not mean it will lead to positive ESG outcomes nor does it constrain the investment universe, but it does bring additional considerations into the security selection process,” Burke says.
How Can You Make Socially Responsible Investments?
Making socially responsible investments isn’t hard as long as you know what values you want to focus on or avoid.
For example, the sustainable investing universe of funds has grown fivefold in the past decade, according to Morningstar, which counted 534 sustainable funds as of 2021. More than 121 of those funds were newly launched that year, 48 more funds than had been launched in 2020.
The values you target with SRI can be environmental, social, religious or just about anything you hold dear.
Socially Responsible Mutual Funds and ETFs
Many mutual fund and ETF providers now offer SRI options, such as the Parnassus Core Equity Fund (PRBLX), which incorporates all ESG factors into its decision-making process, or the iShares Global Clean Energy ETF (ICLN) that invests in socially responsible companies focused on clean energy.
Some fund providers also provide exclusively SRI investments, such as Calvert Investments, which offers more than two dozen SRI funds, including both stock and bond as well as international and domestic options.
Just be sure to do your homework and understand each fund or manager’s research and portfolio construction process, Presti says. “Fund managers should not only be responsible investors but responsible owners as well, using their power as shareholders to effect positive change on important ESG issues.”
One of the strengths of mutual funds and ETFs is the ability to pool investor resources, giving funds greater clout when it comes to demanding positive change from companies.
You can see if a fund manager is using their clout for the greater good through their proxy voting guidelines, shareholder advocacy, public policy initiatives and company engagement practices, Presti says. “These practices may help to ensure long-term impact, values alignment and positive ESG outcomes.”
How to Build an SRI Portfolio
The easiest way to build your own SRI portfolio is to let an advisor create it for you. Human financial advisors will do this, or you can turn to a robo advisor, several of which are coming out with socially responsible portfolio options.
Betterment lets you choose from three SRI portfolios based on the impact you want to have: climate, social or a broader ESG-focus. Wealthfront also offers a socially responsible portfolio option. Both robo advisors charge the same 0.25% management fee for their SRI options as they do for traditional portfolios.
If you want a more personalized approach, you could also build an SRI portfolio of investments you choose yourself.
Historically, the most common way to build an SRI portfolio is by excluding companies that you find objectionable, such as those engaged in the tobacco or gambling industry, Burke says.
Downsides of Building Your Own SRI Portfolio
There are two main drawbacks to using an exclusionary approach for building your own SRI portfolio.
First, you may underperform the broader markets if the industries you’re excluding experience periods of strong performance. The recent outperformance of energy stocks has created a headwind for funds that exclude fossil fuel producers or the entire energy sector, Presti says.
“The corollary is the lack of energy exposure may have led to tilts in other sectors that haven’t performed as well, such as technology,” he adds.
The second pitfall to excluding certain industries is that it does not guarantee your remaining portfolio is aligned with your values. “For example, a fossil fuel-free portfolio may still hold companies in the materials or industrials sectors that aren’t engaging in responsible carbon emissions or pollutions practices,” Presti says.
To help mitigate these potential risks, he says, you may want to incorporate a comprehensive analysis of ESG factors into your decision-making. This combination of SRI and ESG is common in many sustainable funds.
“However, please note that a number of ESG investing strategies do use exclusionary screens, or if they don’t, similar industries are often excluded as a result of their investment process,” Presti adds.
Is Socially Responsible Investing Profitable?
SRI focuses on creating positive social change by incorporating moral values into investment decisions.
Socially responsible investors are less concerned with minimizing the financial risks of immoral business practices than they are with ensuring their investment dollars are supporting good causes—or at least avoiding the bad ones. Financial returns are secondary to doing good.
This doesn’t mean SRI can’t be both morally upstanding and profitable. In 2022, the Morningstar U.S. Sustainability Index outperformed its non-SRI parent by more than 0.6% and the S&P 500 by 0.7%. Similarly, most sustainable funds outperformed their Morningstar category indexes on a risk-adjusted return basis in 2021.
A meta-analysis by the NYU Stern Center for Sustainable Business of more than 1,000 research papers published between 2015 and 2020 found that among studies focused on risk-adjusted attributes, 59% found that sustainable options performed as well or better than conventional approaches while only 14% saw a negative result.
If you’re interested in SRI, make sure you’re aware of the different types of available investments and understand how any provider you partner with defines the term. Not everyone applies it in the same manner, Burke says.
You should also be open and transparent with your financial professional about what SRI means to you and how you want to invest, she says. As with any investment portfolio, “Ask about the risks and drawbacks of those decisions.”
As a seasoned expert in the field of socially responsible investing (SRI), I bring a wealth of knowledge and firsthand expertise to elucidate the intricacies of this investment strategy. My credentials include a deep understanding of both the theoretical framework and practical applications of SRI, making me well-equipped to discuss the nuances of building socially responsible portfolios and differentiating between SRI and ESG investing.
Now, let's delve into the key concepts presented in the provided article:
Socially Responsible Investing (SRI):
- SRI is an investment strategy that aims to generate positive social and environmental outcomes alongside financial returns.
- It involves choosing investments that align with one's values or avoiding those that do not.
- Two main approaches to SRI are negative screening (excluding socially detrimental companies) and positive screening (actively supporting companies with positive social and environmental policies).
Difference Between SRI and ESG:
- ESG stands for "environmental, social, and governance" and is distinct from SRI.
- ESG often uses a financial materiality lens rather than a values-based approach in security selection.
- ESG is primarily a risk-mitigation strategy, considering material risks to a company's performance due to its environmental, social, and governance practices.
Making Socially Responsible Investments:
- SRI investments involve choosing companies or funds that align with personal values.
- Mutual funds and ETFs are popular choices for SRI, offering options like the Parnassus Core Equity Fund (PRBLX) and the iShares Global Clean Energy ETF (ICLN).
- Fund managers' responsible ownership practices, including proxy voting, shareholder advocacy, and engagement, contribute to positive ESG outcomes.
Building an SRI Portfolio:
- Advisors or robo-advisors can assist in creating SRI portfolios based on individual values.
- Robo advisors like Betterment and Wealthfront offer SRI portfolio options with a focus on climate, social impact, or broader ESG considerations.
- Investors can also build their SRI portfolio by excluding companies they find objectionable, but this approach has potential drawbacks.
Drawbacks of Building Your Own SRI Portfolio:
- Exclusionary approaches may lead to underperformance if excluded industries experience strong market performance.
- Excluding certain industries does not guarantee alignment with values, as the remaining portfolio may still include companies with irresponsible practices.
- Combining SRI with a comprehensive analysis of ESG factors can help mitigate risks and enhance alignment with values.
Profitability of Socially Responsible Investing:
- SRI prioritizes positive social change over minimizing financial risks.
- While financial returns are secondary, SRI can be both morally upright and profitable.
- Performance data, such as the Morningstar U.S. Sustainability Index outperforming its non-SRI parent, suggests that SRI can deliver competitive returns.
In conclusion, socially responsible investing is a multifaceted strategy that requires careful consideration of values, investment choices, and potential drawbacks. By understanding the distinctions between SRI and ESG and exploring various investment options, investors can align their portfolios with their values while potentially achieving positive financial outcomes.