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Financial Decoder: Season 7 Episode 2

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Should You Invest in Socially Responsible Funds?

Is investing in socially responsible funds the right move for your portfolio?

When you invest, are you simply trying to make as much money as possible without taking on too much risk? Or are you trying to accomplish other goals as well, perhaps making sure that your investments align with your values, or that you’re using your money to help make a positive difference in the world? If those latter goals matter to you, you might be interested in socially responsible investing, or SRI.

Michael Iachini, vice president and head of manager research for Charles Schwab Investment Advisory, joins Mark to discuss the differences between SRI, ESG, and impact investing; what to look for in an SRI fund; and the history of performance of these funds, broadly.

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MARK RIEPE: Over the past year, many of us have paid more attention to cleaning surfaces than we ever have.

If you want to clean your kitchen counter, you can use traditional cleaning products or so-called “green” products. Defenders of traditional cleaners say they’re more effective and less expensive.

Those who prefer green cleaners say they clean just as well and are less toxic to your health and that of the environment. Which is better? Well that’s hard to say because the answer depends on your preferences.

According to some studies, for basic cleaning, traditional and green products yield similar results. And some natural substances go beyond cleaning and can disinfect as well.

For example, limonene, found in citrus fruits, has antiviral properties, and white vinegar can kill certain bacteria, such as E. coli and salmonella.[1]

So as far as effectiveness goes, I’ll call it a draw. As for safety, yes, chemicals in some traditional cleaning products can irritate the skin, eyes and respiratory tract. But natural cleaners can be corrosive, too. In other words, just because a product is made “naturally” doesn’t necessarily prevent it from having some degree of toxicity.

Another dimension to help you decide is cost. You can create your own green cleaner by buying the raw ingredients and mixing them yourself.

A gallon of white vinegar sells online for $2.64[2], and then you have to take into account the cost of the spray bottle as well as the opportunity cost of your time.

If you want to buy a manufactured green cleaner, on the other hand, that can cost up to three times more than traditional cleaners.[3]

The bottom line is that natural cleaners clean just as well as traditional cleaners and not all natural cleaners are inherently safer. Conversely, traditional cleaners are not automatically more effective or more toxic than natural cleaners. Cost is all over the map depending on what you buy.

I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.

The reason I’m even talking about cleaners today is that the traditional-versus-green-cleaner debate is similar to the discussion around investing according to your values or to make a positive change in the world.

Proponents of this kind of investing say that you’ll get better returns and improve the well-being of the planet and all living things.

Those who don’t like it say that your portfolio will be riskier because it’s more concentrated, and investing should be about returns, and social issues should be dealt with in another manner.

Now, I’m simplifying these viewpoints of course, but the point is that there are a lot of similarities with the cleaner discussion, and my guest will help shed some light on this topic.

MARK RIEPE: Joining me now is Michael Iachini. Michael is a vice president at Charles Schwab Investment Advisory and head of manager research. Now, that covers everything from mutual funds, exchange-traded funds, separately managed accounts, and alternative investments. He also has a couple of designations, the Chartered Financial Analyst and CERTIFIED FINANCIAL PLANNER™ designations. Thanks for joining me today, Michael.

MICHAEL IACHINI: My pleasure, Mark.

MARK: Michael, the financial services industry, it’s got a lot of terminology that many investors find confusing, and the investing strategy that we’re going to be talking about today, it actually goes by many different names. So I thought we could start out by going through a few of those names, and you can tell me what they mean and the subtle differences between them. So let’s start with socially responsible investing, or SRI. What does that mean?

MICHAEL: Yeah, so socially responsible investing, or SRI, it can be used as a really broad umbrella term to talk about a lot of different types of investments under this umbrella, but really it’s most commonly used to refer to investment approaches that exclude certain sectors or certain types of companies, such as tobacco, firearms, or fossil fuels companies. So you might see SRI referred to as exclusionary or values-based investing.

MARK: SRI is also … although it seems to be the name most familiar to individual investors, perhaps because it’s the kind of the oldest form of this type of investing, but within the industry and financial media, probably the most popular term these days is ESG investing. So what does ESG stand for, and how does that differ from SRI?

MICHAEL: Sure. So ESG stands for “environmental, social, and governance” investing. This approach means you’ll take account of environmental, social, and governance factors when you’re choosing your investments. ESG strategies are typically going to be more similar to broad benchmarks than the SRI strategies are. So, usually, ESG strategies will include some exposure to all of the economic sectors, rather than completely excising certain sectors as unacceptable. It’s common for ESG strategies to include exposure to potentially objectionable industries via stocks that are best-in-class, for instance, energy companies that are investing in non-fossil fuels in addition to their main line of business. So that is, ESG strategies are more likely to include the “less bad” companies within various industries, thus keeping the overall industry exposures in line with the broad market. And sometimes, you’ll also see these ESG strategies referred to as integration strategies.

MARK: Michael, it’s hard to generalize, but it sounds like ESG funds are evaluating companies on a much broader set of criteria than SRI. Is that accurate?

MICHAEL: Yeah, in general, that’s right. SRI tend to be a pretty strict screen on a specific issue. So if a company is involved in a particular industry, with SRI, it’s just excluded. With ESG, on the other hand, you’ll usually consider several different factors and decide which specific companies are overall better or worse choices from an environmental, social, or governance perspective. It’s less of a binary yes/no decision with ESG.

MARK: Another term I’ve seen out there is impact investing. So could you distinguish impact investing relative to ESG and SRI?

MICHAEL: Sure. So impact investing refers to explicitly deploying your investment dollars in an effort to directly achieve some kind of desired outcome. So examples here with impact investing might include financing loans to a low-income home buyer or group of them, funding a project to reduce air pollution at factories, buying stock in a company so that you can make an effort to put positive shareholder initiatives on that company’s proxy ballot, and things like that. Impact investors are typically most concerned with changing the world or changing the companies they’re investing in. And then the investment returns part, that tends to be secondary for impact investors.

MARK: There are lots of different SRI and ESG funds. I think we’ll be talking about that a little bit later. Impact investing, though, it seems like it’s more of a direct investment in a project instead of owning a fund. Is that right? Is that the way to think about it?

MICHAEL: Sort of, yeah. The clearest path to making an impact with your investment dollars, yeah, it definitely is through directly investing in a project that will make a difference, but that’s not always easy for individual investors to do, though. It just might not be practical for an individual to directly lend to people who will use the money to make a positive social or environmental impact. So there are funds that try to do that form of investing using their shareholders’ dollars, but investing more directly where possible does make it clearer to see the impact your investment is having.

MARK: Whatever you call it, is this one of these cases where you need to either be fully committed to these types of strategies or stay away from it completely, or is there a middle ground?

MICHAEL: No, absolutely not. It doesn’t have to be all or nothing. If you’re interested in these factors, whether it’s SRI, ESG, impact—however you’re describing it—we see investors as being somewhere on a spectrum. So on one side, you could say, they’re all-out—environmental, social, and governance factors just don’t matter at all to their investment decisions. And at the other end of the spectrum, you do have investors who we would describe as all-in, where these factors come even before considerations of risk and return. But it’s a spectrum. There’s a lot of points in between.

It’s completely fine to take a traditional portfolio where you haven’t considered any of these factors before, and then you add a single ESG mutual fund or maybe an exchange-traded fund to that portfolio. Is also fine toward the other end of the spectrum is to have a portfolio where you’re mostly considering ESG factors, but you do use some non-ESG funds for certain parts of the market where you can’t really find ESG options, or the ones that are out there are unattractive. So you can definitely be somewhere in between all-out and all-in when it comes to ESG and SRI.

MARK: Let’s talk a little bit about how you actually go about making these investments, what sort of investment vehicles exist. We’ve got a lot of different types of investors listening to the show. So what are the different types of securities that can be used?

MICHAEL: You have some choices for sure. So I’ll cover the main popular ones. I think best known would be mutual funds. Of course, a lot of investors have used mutual funds. There’s a lot of choices out there. And if you want something within an ESG or SRI focus, you’ve got over 350 choices out there, and most of these funds are actively managed in the mutual fund space. You might also consider an exchange-traded fund, or an ETF. Now, with ETFs, there aren’t as many choices yet, but it is growing. You’ve got around 80 or so funds across 25 different categories. And with ETFs, unlike mutual funds, most of the funds are going to be index funds of some sort.

Beyond mutual funds and ETFs, you also can consider separately managed accounts. So this is where you hire a professional to manage a portfolio of stocks, or bonds, or other assets on your behalf, and they will directly implement a strategy that can have an ESG or SRI bent.

And then, of course, for those investors who really want to get their hands dirty, you can take on a full do-it-yourself approach. So this would be where you do the research yourself, you research specific stocks and bonds on the companies that have better or worse characteristics from an SRI, or ESG, or impact perspective, you do the research, you buy the stocks and bonds that you want, and you build up a portfolio from the ground up that fits your values most closely.

MARK: Michael, a lot of what you just discussed, a lot of that stuff is the sort of thing that you would do with a brokerage account. What about the 401(k) investor? How can they participate?

MICHAEL: Yeah, if you’re talking about your 401(k), you have a couple of different choices. So, first of all, most 401(k) plans will have a lineup of mutual funds available to choose from, and in some plans, there will be an ESG or an SRI option or two available. So I’d say, start there and look at your fund lineup. You might have some of these choices already at your fingertips. If you don’t, or if you don’t like the choices that are available, you might also see whether your 401(k) plan has a brokerage window option, in which you can say, “I want to put some of my 401(k) dollars sort of into a brokerage account.” And in that account, you can choose from all the different ESG mutual funds and ETFs that are out there. So even within a 401(k), you’ll often have an opportunity to pick an ESG or SRI fund that might align better with your values.

MARK: So let’s drill down a little bit on funds since mutual funds and ETFs are probably the most popular of the choices you just listed. Are the funds that are out there, are they spread out across lots of different asset classes, or are they just concentrated in a few asset classes, and because of that, it would be hard to make a full-fledged diversified portfolio?

MICHAEL: There are ESG funds available across a pretty broad range of asset classes. Now, today, most of the choices are in actively managed U.S. equity funds. That is where you’re going to see the most choices, because that’s really where SRI and ESG investing started. But there are also plenty of international equity choices and growing numbers of taxable bond and even a few municipal bond fund options out there. Among ETFs, by contrast, most of the choices are index funds. I mentioned earlier that mutual funds tend to be actively managed. ETFs tend to be index funds. And, again, the ETFs are more heavily tilted toward the equity side. But there are some ESG bond ETFs out there, and this is an area where we’ve seen investment managers continuing to launch new funds all the time.

MARK: Michael, I’m going to go back to something you talked about earlier. When it comes to the portfolio management, some managers completely exclude certain industries, whereas others, they won’t necessarily exclude an entire industry, but instead exclude companies within that industry that score the worst on their ESG criteria. So how should an investor think about those two approaches? How should that investor make a decision as to which path makes the most sense for them?

MICHAEL: Yeah, the exclusionary approach is great for those investors who want to take a firm stand against having any exposure to an industry they don’t like. You can think of this as a form of divestment. You simply choose not to own certain types of companies. Now, there’s some risk here, of course—there’s really sector risk. If you have zero exposure to an industry, that means your overall performance will lag the market if that’s the industry that performs really well in a particular time period.

The other approach where you do include companies from all these industries, we sometimes call that best-in-class, like I mentioned earlier with ESG. So you’ll target those companies within each industry that are doing better than their peers on these environmental or social or governance characteristics. So you might have an energy company that does produce petroleum, but they’re doing so as part of a mix that includes clean energy, or they refine oil in a lower pollution manner than their competitors, or something like that. So in this way, with this best-in-class approach, you alleviate the sector performance problem I talked about earlier, but you have to be comfortable with the portfolio that includes industries that might not align with your values perfectly.

MARK: There’s also a certain amount of subjectivity when it comes to evaluating companies in this manner. There are a lot of different firms out there who, you know, provide ratings on companies on different environmental, social, and governance factors, but those companies, they’ll disagree from time to time on how specific companies rank. So what advice do you have on how investors are supposed to deal with this?

MICHAEL: Yeah. Well, first, you just have to be aware of this subjectivity. There’s just no universal truth on how to evaluate ESG factors. Different data providers do it differently. The same company can get a high ESG score from one provider and a low score from another provider, because maybe those providers use different metrics to evaluate a firm, or maybe they weigh different issues of those companies in a different way.

Second, beyond awareness is you have to decide whether you want to rely on data providers alone. If you’re using an ETF or a mutual fund, for instance, you are relying on someone else to evaluate companies for you, and that might be the right tradeoff for you. It certainly saves a lot of effort. But if you’re doing the research yourself, you’ll want to look at the components of the ESG rating for any company you’re considering owning. You might find that the company has an overall high score from one data provider, but it has one or two specific areas on which that company rates poorly. If those are the areas you care most about, then you probably won’t want to own that company despite the high score.

MARK: I think the number one question that people have is what effect on performance do these sorts of criteria have? Some people claim that it actually helps performance. Other people claim that it actually hurts performance. Where do you stand?

MICHAEL: Yeah, this is something we’ve done a lot of research on, and based on that research, my opinion is that ESG or SRI is neutral for performance. In some time periods, it’s helped. In some time periods, it’s hurt. But, overall, there’s really no clear pattern of focusing on these ESG or SRI factors being better or worse from a risk and return perspective than ignoring them. And one good way to see if ESG is helping or hurting performance is to see how these kinds of mutual funds rank in their performance compared to all mutual funds.

So the way we did this is we collected a bunch of data on these ESG and SRI funds that are out there, we went all the way back to 2010, so through the last 10 years, and we looked at rolling three-year periods. So in any given window of three years, how did the average ESG fund rank? And if a fund was going to be right in the middle of the category, that will be the 50th percentile. Top of the category will be the first percentile. Bottom would be 100th percentile. What we found was ESG funds tended to stick in the middle. ESG funds, overall, had some periods where they were better, ranking maybe as high as the 39th percentile, some periods where they were worse, maybe as low as the 60th percentile, but that’s always within 10 or 11 points of the middle. So, basically, ESG funds overall were always very close in performance to the middle of the category as a whole, which is why we say that ESG is really neutral when it comes to performance.

MARK: And just to kind of emphasize that point, when you were talking about ESG funds overall, you mean the average ESG fund within its category?

MICHAEL: Exactly. We took a look at a whole bunch of different categories, and when we grouped them all together and saw how all of the ESG funds rank across all those different categories, they tended, on average, to be very close to the middle.

MARK: Michael, what about last year? 2020 was a crazy year in the markets and the economy. Did you notice any performance difference from the historical averages last year?

MICHAEL: Sure. Yeah, so for the year 2020, ESG funds did very well overall. They easily beat their non-ESG peers in nine out of the 10 biggest ESG categories, which is great. If you had ESG exposure in 2020, you were probably pretty happy, but just because ESG did well in 2020, it doesn’t tell us much about how it will do in 2021 or beyond. We think it’s really smartest to think about ESG investing based on whether it fits your values or not, rather than investing with the expectation of higher returns, or on the flip side, assuming that you’ll have to accept lower returns. From all of our research, we see that ESG looks to be neutral for fund performance overall.

MARK: Michael, do you get the sense that traditional money managers are looking at the types of issues and factors that an ESG manager is looking at, even if they don’t call themselves explicitly an ESG manager?

MICHAEL: When it comes to governance, in particular, the G in ESG, yes, absolutely. Traditional money managers often consider whether a company has good governance. Do they have appropriate board expertise on their board of directors? Are there accounting practices following generally accepted guidelines? Do they have strong transparency in their business practices and so on? So, yeah, governance is very commonly a factor for all money managers, not just ESG money managers.

From a social and environmental perspective, that’s the S and the E in ESG, some traditional money managers do consider these issues from time to time. So, for instance, you might see there’s a company that has a poor environmental or poor social record, that company might be vulnerable to action from government regulators or they might face some lawsuits. And if you’re going to face large fines or potential legal judgments, that could be a big negative for a company’s profitability. So even non-ESG money managers are likely to take those issues into account.

But the real difference is the way that these non-ESG money managers describe these factors tends to sound pretty different from the way that ESG managers talk about them. From those non-ESG managers, you will tend to hear less about improving the world and more about anticipating risks. That’s how the traditional money managers tend to describe these factors.

MARK: This has been great, Michael. Thanks for stopping by.

MICHAEL: Thank you for inviting me, Mark.

MARK: If you’re going to invest your money you need a strategy. There are many investment strategies.

Indexing, focusing on high-octane growth stocks, buying exceptionally cheap stocks that are unloved and undervalued—these are all examples of strategies.

Each strategy involves methods for evaluating securities and determining which ones to buy, which ones to hold, and which ones to sell.

The way I think about it is that ESG, SRI, and impact investing are all just other forms of investment strategies that one could choose. Because we’re all different, it’s impossible to make a blanket statement on something so personal.

Before you pick a strategy, though, you need to define what success looks like to you as an investor. And just as there are many strategies, there are many definitions as to what constitutes a successful portfolio. Some investors seek only to achieve the highest return. That’s just fine.

But others use a broader range of success metrics.

The most common is the consideration of risk in addition to return. Everyone likes high returns, but many don’t have the stomach for taking the high risks that are often necessary to achieve high returns.

Risk and return are dimensions that only focus on the portfolio itself. An additional dimension of success evaluates the portfolio in conjunction with its ability to serve a purpose. In other words, a successful portfolio is one which serves as a means to an end.

The portfolio is successful if it helps make the investor’s goal a reality. For example, my investing has been successful if I achieved my goal of being able to afford a comfortable retirement.

The goals of an ESG investor go beyond traditional economic measures of risk and return. The investor’s preferences matter as well. The portfolio can be an expression of the investor’s beliefs.

The title of this episode is “Should You Invest in Socially Responsible Funds?” The answer is that it depends.

Like I said, investing is a means to an end and not an end unto itself. If having higher risk-adjusted returns than peers is an investor’s only goal, then ESG funds, on average haven’t consistently demonstrated an ability to achieve that goal.

But investors have different goals, and it isn’t my job or anyone else’s to tell you what your goals should be as an investor.

My advice is to pick your goals and then match up your investing strategies with those goals.

One more thing: There are many, many different versions of ESG, just as there are many, many versions of non-ESG investment management.

The empirical results on performance that Michael spoke about earlier were based on broad averages. Every fund is likely to be different.

Also, the approach to ESG that these funds take also varies from fund to fund. Find the fund that matches with what’s important to you.

What you don’t want to do is fall prey to the halo effect. This is a cognitive bias where if you find one feature that’s attractive in a person or a thing, you then automatically ascribe positive attributes to all of their features.

This applies to ESG investing because just because the fund has good intentions or says all the right things, that doesn’t necessarily mean they’ll be able to execute a successful investing strategy in the real world.

So you really need to do your due diligence on the fund. What is their management experience? How does the fund construct its portfolio? What’s the fund’s track record? How do they specifically define E, S, and G?

We have many more resources related to ESG and socially responsible investing at Schwab.com/SRI.

There you can learn more about the ETFs and mutual funds Michael mentioned, as well as some answers to frequently asked questions.

Thanks for listening.

If you’re on Twitter, please give me a follow @MarkRiepe. M-A-R-K R-I-E-P-E.

We’d also appreciate it if you could leave us a rating or review on Apple Podcasts. We’d love to hear from you there.

Now I want to go back to our last episode and clear something up.

I referenced what I called the apocryphal story of the ostrich who puts their head in the sand to avoid danger.

I was right that ostriches don’t put their head in the sand to avoid danger.

What I didn’t know was that ostriches do dig holes in the dirt and use as nests for their eggs.

They frequently stick their heads in these nest holes to check on their eggs—not necessarily to hide from a predator. Thank you, Colette, for setting me straight and helping us bust that myth.

That’s it for today’s episode.

For important disclosures, see the show notes and Schwab.com/FinancialDecoder.

Important Disclosures:

Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk including loss of principal.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.

Socially screened strategies exclude certain investments and therefore may not be able to take advantage of the same opportunities or market trends as strategies that do not use social screens.

Charles Schwab Investment Advisory, Inc. ("CSIA") is an affiliate of Charles Schwab & Co., Inc. ("Schwab").

Apple Podcasts and the Apple logo are trademarks of Apple Inc., registered in the U.S. and other countries.

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