Building A Socially Responsible Investment Portfolio: Doing Well By Doing Good

Socially responsible investment (SRI) is an investment strategy that aims to generate both social change and financial returns for an investor. It involves investing in companies and funds that have positive social impacts and avoiding those with negative impacts. SRI investors encourage corporate practices that promote environmental stewardship, consumer protection, human rights, and racial or gender diversity. The primary goals of an SRI portfolio are to align investments with personal values, promote responsible corporate behaviour, and generate competitive financial returns.

Positive and negative screening

Positive Screening

Positive screening identifies and focuses investments into companies that are considered top performers based on chosen criteria. These criteria are often linked to environmental, social and governance (ESG) topics. Positive screening, or 'best-in-class screening', identifies and highlights organisations that are actively functioning to further environmentally sustainable and positive social practices. It encourages companies to compete with each other for investment dollars.

Negative Screening

Negative screening, or exclusionary screening, is one of the most basic methods of separating socially responsible investments from those that are likely to have a negative effect on society. It is much less restrictive than positive screening and simply excludes investments in companies that actively work against the investor's values. Negative screening works to remove investments in entities that are deemed to have a negative impact on society or the environment from the investor's portfolio.

History

The origins of SRI may date back to the Religious Society of Friends (Quakers). In 1758, the Quaker Philadelphia Yearly Meeting prohibited members from participating in the slave trade. One of the most articulate early adopters of SRI was John Wesley (1703–1791), one of the founders of Methodism. Wesley's sermon "The Use of Money" outlined his basic tenets of social investing: not to harm your neighbour through your business practices and to avoid industries like tanning and chemical production, which can harm the health of workers.

The modern era of SRI evolved during the socio-political climate of the 1960s. During this time, socially concerned investors increasingly sought to address equality for women, civil rights, and labour issues. Economic development projects started or managed by Martin Luther King, such as the Montgomery bus boycott and the Operation Breadbasket Project in Chicago, established the early model for SRI efforts.

Effectiveness

There is debate about the effectiveness of negative and positive screening. Some studies have shown that SRI mutual funds can not only match traditional mutual funds in performance but can sometimes perform better. There is also evidence that SRI funds may be less volatile than traditional funds. However, critics say that any approach that reduces the universe of potential investments will result in sacrificed performance.

A 2015 review by Morgan Stanley of 10,000 funds concluded that "strong sustainability" investments outperformed weak sustainability investments. However, a 2017 study by Pieter Jan Trinks and Bert Scholtens found that controversial investments generally yield positive abnormal returns, and that screening produces suboptimal financial performance.

Impact investing

Within impact investing, there is a varying prioritisation of positive impact creation in relation to financial returns. Some impact investors seek competitive or market-rate returns, while others may be willing to accept below-market returns to maximise their positive impact. However, fiduciary responsibility to investors and the pursuit of positive impact are not mutually exclusive, and there is growing evidence that impact investments can produce market-rate or even outperform non-impact investments.

In 2014, the UK's presidency of the G8 established a Social Impact Investment Task Force, which defined impact investing as "those that intentionally target specific social objectives along with a financial return and measure the achievement of both". This task force highlighted the potential for impact investing to drive social change and attract a wide range of investors.

Overall, impact investing offers a proactive approach to socially responsible investing, integrating social and environmental factors while actively seeking out investment opportunities that generate positive social and environmental impacts, alongside financial gains.

Shareholder engagement

The benefits of shareholder engagement extend beyond promoting responsible corporate behaviour. It also enables investors to gain a deeper understanding of the companies they invest in, assess their commitment to ESG practices, and make more informed investment decisions. Additionally, shareholder engagement can help identify companies that are responsive to stakeholders' concerns and demonstrate a willingness to improve, enhancing the overall sustainability of the investment portfolio.

Furthermore, shareholder engagement can contribute to risk mitigation by identifying potential ESG-related risks and encouraging companies to adopt more sustainable practices. By actively engaging with investee companies, investors can stay informed about emerging ESG trends and integrate this knowledge into their investment strategies. This proactive approach helps investors avoid potential negative impacts associated with poor ESG performance and enhances the long-term sustainability of their investment portfolios.

In summary, shareholder engagement is a vital tool for investors to drive positive change, promote responsible corporate behaviour, and ensure their investments align with their values and ESG goals. By actively engaging with investee companies, investors can influence corporate decision-making, mitigate risks, and contribute to a more sustainable future while potentially generating competitive financial returns.

Assessing and identifying ESG factors

Environmental Factors:

• Climate Change and Greenhouse Gas Emissions: Evaluate the company's direct and indirect greenhouse gas emissions and their impact on climate change. Consider their climate mitigation strategies, such as renewable energy usage and carbon footprint reduction.
• Natural Resource Management: Assess how the company stewards natural resources, including water, biodiversity, and raw materials. Look for responsible practices that minimise negative environmental impacts.
• Pollution and Waste Management: Examine the company's policies and track record on pollution prevention, waste reduction, and sustainable waste management practices.

Social Factors:

• Human Capital Management: Evaluate the company's treatment of its employees, including fair wages, employee engagement, health and safety, diversity and inclusion, and overall working conditions.
• Community Impact: Consider the company's impact on the communities in which it operates. Assess their contributions to local development, social welfare, and environmental sustainability.
• Supply Chain Management: Analyse the company's supply chain practices, especially in developing economies, to ensure ethical labour standards and environmental responsibility.

Governance Factors:

• Leadership and Accountability: Assess the company's leadership structure, including board diversity, executive compensation, and internal controls. Evaluate their commitment to transparency, accountability, and ethical decision-making.
• Shareholder Rights and Relations: Understand how the company views and honours shareholder rights. Evaluate their practices for shareholder engagement, communication, and conflict resolution.
• Business Ethics and Compliance: Review the company's track record on business ethics, including anti-corruption measures, data privacy, and adherence to legal and regulatory standards.

It is important to note that the assessment of ESG factors is an evolving field, and new considerations may emerge over time. Additionally, the weight assigned to each factor may vary depending on the industry, geographical location, and other contextual factors.

Building a socially responsible portfolio

Building a socially responsible investment (SRI) portfolio is a great way to foster positive social and environmental outcomes while also generating positive returns. Here are the steps to build a robust SRI portfolio:

Identify your values and goals:

Start by identifying your core values, social and environmental concerns, and financial objectives. This will help you create a well-aligned investment strategy that reflects your beliefs and priorities.

Conduct thorough research:

Research companies' environmental, social, and governance (ESG) performance, financial health, and growth prospects. Look into independent research firms' ratings and screens, which evaluate companies on various risk factors and assign aggregate scores. This will help you select investments that meet both your ethical and financial criteria.

Choose your investment vehicles:

You can invest directly in individual stocks and bonds of companies with strong ESG performance. Alternatively, consider ESG-focused exchange-traded funds (ETFs) and mutual funds, which offer diversified exposure to socially responsible companies across sectors and regions. Socially responsible index funds, green bonds, and impact bonds are also options to explore.

Diversify and manage risk:

Diversify your portfolio across different asset classes, sectors, and regions to manage risks effectively. Regularly review your portfolio's performance to ensure it remains aligned with your values and financial goals. Stay informed about new ESG developments to make informed decisions and maintain a relevant, up-to-date portfolio.

Engage with companies:

As a shareholder, you can engage with companies to promote responsible practices and encourage ESG improvements. Use your ownership rights to influence corporate behaviour through voting, dialogue, and advocacy. This will help ensure that your investments have a positive impact and are aligned with your values.

Measure the impact:

Use quantitative metrics, such as standardised ESG ratings and emissions data, to measure the impact of your SRI portfolio on society and the environment. Also, consider qualitative factors like corporate culture, stakeholder engagement, and innovation to evaluate the broader effects of your investments. Compare the performance of your SRI portfolio with traditional portfolios to demonstrate the financial viability of responsible investing.

Challenges and criticisms:

Be aware of potential challenges and criticisms of SRI, such as greenwashing, misleading ESG claims by companies, and potential trade-offs between financial returns and social impact. Additionally, the evolving definitions and standards for ESG criteria can create inconsistencies and confusion for investors when evaluating companies.

Frequently asked questions