Building a Socially Conscious Investment Portfolio

Some people have investing goals that go beyond earning a return. For those who want to use their investment dollars to support their personal values, socially conscious investing—which seeks to deliver environmental and social improvements alongside competitive financial returns—is one way to go.

Once considered an investment fad, socially conscious investing is today a $12 trillion business,¹ with nearly 400 exchange-traded funds (ETFs) and mutual funds guided by socially responsible investing (SRI) strategies.² What’s more, these funds have demonstrated they can keep up with—if not exceed—the performance of more traditional funds.

So, how do you go about identifying and selecting an SRI fund that aligns with your values? Here are three factors to consider.
 

1. Investment approach

Most SRI funds follow one of three strategies:

• Exclusionary: A fund manager begins with a broad market index—say, the S&P 500^®—and then removes those companies that don’t align with the fund’s stated social goals. Some funds exclude companies in certain lines of business—firearms, gambling or tobacco, for instance—while others screen based on company behavior, such as those in violation of international human rights standards. Exclusionary approaches may eliminate entire sectors, which could reduce diversification and lead to significant performance differences relative to a fund’s benchmark index.
• Thematic: Employing an inclusive rather than exclusive approach, fund managers use environmental, social and governance (ESG) criteria—such as business ethics, carbon emissions and human rights—to determine a company’s ethical and environmental impact and potential future financial performance. Thematic funds tend to be dominated by a single industry and concentrated on issues such as air quality, alternative energy or clean water. Because thematic funds are relatively narrow in focus, they may be better suited to the margins of your portfolio.
• Best in class: A fund manager selects securities based on strong ESG criteria relative to industry peers. Best-in-class funds may therefore include defense, energy, paper/timber and utility companies among their holdings—sectors that might be prohibited by other SRI approaches. Though often more diverse, these funds might be regarded as less socially responsible than exclusionary or thematic SRI funds.

Be that as is may, the methodology used to score companies and optimize performance can get complicated. What’s more, the skill of the manager and the rules governing the construction of the SRI index (in the case of passively managed funds) are of key concern. Make sure you understand both when selecting an investment that’s suitable for you.
 

2. Performance

For years, critics argued that SRI investors sacrificed performance on the altar of good intentions. While that may have been the case in the past, today’s SRI funds have been keeping pace with their non-SRI peers.

For example, the MSCI KLD 400 Social Index produced an average annual return of 7.53% over the 15-year period ending December 2018—just a quarter of a percentage point below the S&P 500’s 7.77% over the same period.³ And 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 “Doing well by doing good,” below).
 

Doing well by doing good

Over the past decade, SRI funds have slightly outperformed non-SRI funds.

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. Morningstar defines funds as socially responsible if they invest according to noneconomic guidelines such as environmental responsibility, human rights or religious views.
 

That said, many SRI funds have limited performance histories, meaning it may not be clear how they will perform under varying market conditions.
 

3. Fees

Selecting companies for socially responsible funds is an involved, time-consuming process that requires specialized skills, which may lead to higher operating expense ratios than those of comparable non-SRI funds—although SRI pricing has become more competitive over time.

Of the funds that Morningstar identifies as socially conscious, for example, 53% have lower expense ratios than their non-SRI peers.⁴ You should nevertheless determine for yourself whether the fees associated with a particular SRI fund are acceptable vis-à-vis its non-SRI counterparts.
 

Building a values-based portfolio

While most socially conscious funds are eager to advertise their bona fides, don’t assume that an SRI fund aligns with your values until you have verified its holdings and methodology. One resource is a fund’s prospectus document, which details principal investment strategies and risks, among other information.

Schwab’s ETF screener and mutual fund screener both have filters that allow clients to find and compare SRI funds that meet certain ESG criteria. You can also consult the Schwab Socially Conscious Funds List to find socially responsible ETFs and mutual funds prescreened by Schwab experts.

¹Report on US Sustainable, Responsible and Impact Investing Trends 2018, ussif.org.| ²Morningstar Direct, as of 12/31/2018. | ³Ibid.| ⁴Ibid.