There’s never been a more opportune time to sync your personal values with your investments. Socially responsible investing (SRI)—which seeks to effect positive social change while also potentially generating competitive financial returns—has emerged as a significant, grass-roots trend.
Since the Forum for Sustainable and Responsible Investment (US SIF) began researching SRI in 1995, the assets in these types of investments have grown from $639 billion to nearly $12 trillion. That’s an 18-fold increase and a compound annual growth rate of 13.6%.1
What’s more, great strides in data collection and a slew of new online tools have made identifying such funds a matter of a few clicks and keystrokes. For example, Schwab’s exchange-traded fund (ETF) screener and mutual fund screener both have “socially conscious” filters that allow clients to find and compare SRI funds that meet certain environmental, social and governance (ESG) criteria. These are the three central factors used to measure an investment’s sustainability and ethical impact.
Here are some examples of socially responsible topics that fall under each of those topics.
Types of SRI funds
There are multiple ways to address environmental, social and governance criteria in an investment strategy. But most SRI funds are created by the fund companies using one of these three approaches:
- Begins with a broad index, like the S&P 500® Index.
- Removes companies based on business activities (for example, energy or tobacco companies) or behavior (for example, violating international human rights standards)
Either type of these removal approaches may result in entire sectors or industries being excluded. Depending on the size and impact of the companies removed, this could potentially lead to significant performance differences vs. a broad index.
- Thematic investing
- Focuses exclusively on companies which are attempting to capture ESG trends
- Tends to be dominated by a single industry or sector
- Tends to concentrate on environmental issues (for example air, water, alternative energy and agriculture)
Thematic investing goes even further than exclusionary screening. Generally, these types of funds may be better suited for non-core positions within a portfolio.
- Best-in-class selection
- Seeks to track performance of a broader, non-SRI benchmark.
- Could have energy, defense, utilities or timber/paper companies among its holdings
These funds may overweight companies which rate well on ESG characteristics and underweight lower-rated companies in the same sector or industry. Other factors may also be optimized in an attempt to generate returns which are similar to a non-SRI benchmark. The skill of the manager or—in the case of passively-managed funds—the rules governing the construction of the SRI index are key.
SRI performance and fees
Far from compromising on returns, SRI funds have tended to keep pace with non-SRI options. For example, the MSCI KLD 400 Social Index averaged an annual rate of return of 7.53% versus 7.77% for the S&P 500® Index over the 15-year period ending in December 2018.2
Additional data from Morningstar shows that, on average, SRI mutual funds have slightly outperformed their non-SRI counterparts in the short, medium and long terms (see below).
SRI and non-SRI fund performance
Source: Charles Schwab Investment Advisory, Inc., with data from Morningstar, as of 12/31/2018. Returns represent the average annualized performance of U.S. equity open-end socially responsible and non–socially responsible mutual funds. Past performance is no guarantee of future returns. The number of socially responsible funds with 3 year returns is approximately 316, compared to over 6,500 non-socially responsible funds. Morningstar defines funds as socially responsible if they invest according to noneconomic guidelines such as environmental responsibility, human rights, or religious views.
If matching the returns of a broader index is your goal, then be sure to look for an SRI fund that optimizes or attempts to match the returns of the broader asset class with a best-in-class approach to security selection and weighting.
If you’d prefer to concentrate your portfolio on a single ESG issue or exclude certain sectors/industries from your portfolio, and you’re okay with your returns potentially being very different from the broader index or asset class, an exclusionary or thematic fund may be right for you.
Finally, watch out for fees. Selecting companies for socially-responsible funds is an involved, time-consuming process that requires specialized skills. Nevertheless, you should confirm that the management fee seems reasonable compared to the fees on similar SRI and non-SRI funds.
Fortunately, the fees on SRI funds have become more competitive over time and seem to be trending down. Out of the 395 mutual funds that Morningstar identifies as socially conscious, over half (53%) had lower expense ratios than the non-SRI funds in the same category.3
Building a values-based portfolio
While the number of ESG funds has increased, it can still be challenging to create an ESG portfolio that reflects your values and is adequately diversified. Be prepared to do a bit of digging to find the right SRI fund that fully aligns with your principles.
While it’s easy enough to find a like-minded ETF if you’re interested in a single theme, what if you have multiple goals like pinpointing sustainable-energy companies with boards that reflect gender and racial diversity?
Or, what if you’re looking for an ESG fund that is completely fire-arms free? In the wake of multiple mass shootings, some ESG investors were surprised to learn that their funds excluded military arms and weapons manufacturers but not civilian firearms.
In response to investor demand, iShares changed the indexes on its suite of ESG ETFs to “extended” versions to screen out both producers and retailers of civilian firearms.4
While most socially conscious funds are eager to advertise their bona fides on their websites, don’t assume that an ESG fund aligns with your values until you have verified its holdings and methodology.
With socially-conscious bonds, creating a values-based portfolio with adequate diversification is particularly difficult. That’s because the lion’s share of the U.S. bond market is made up of Treasuries and mortgage-linked bonds. The impact of these investments is difficult to measure, and that makes it challenging to apply SRI standards.
That said, there are SRI funds for corporate bonds, international stocks, and U.S. large- and small-cap stocks. There are even balanced funds that blend socially responsible bonds and stocks within a single investment vehicle.
Risks and opportunities of socially-responsible investing
Like most things, making an SRI investment is not without risks. In an August 2018 Investor Bulletin, the SEC highlighted a few things to consider before investing in any ESG or other non-traditional fund.5
- Lack of correlation – SRI funds may perform differently than non-SRI alternatives in the same category or asset class
- Returns – These funds may have limited performance histories, and it may not be clear how they will perform under different market conditions
- Diversification – Be sure to understand how the strategy over- and under-weights its holdings. Make sure the investment is as diversified as you think it should be.
- Complexity – The techniques used to score companies and optimize performance to match the returns of a broader index or asset class may be complicated. Make sure you understand the logic and are comfortable with the level of complexity.
- Cost – These funds may have higher expense ratios than non-SRI alternatives
Once you understand the risks, you may find that making a social impact with your portfolio is the right way to go.
1The Forum for Sustainable Responsible Investment, 2018 Report on US Sustainable, Responsible and Impact Investing Trends
2,3Morningstar Direct, as of 12/31/2018.
4Blackrock, Client Update on Civilian Firearms Exposure in Investment Portfolios, 3/2/2018
5U.S. Securities and Exchange Commission, SEC Investor Bulletin: Smart Beta, Quant Funds and other Non-Traditional Index Funds, 8/6/2018