It is time to rethink socially conscious investing

The fastest-growing segment of managed money is socially conscious investing, which accounts for more than $2.2 trillion in assets, or one in every $10 invested, according to the Social Investment Forum in Washington.
With its growing clout come learning pains and questions about definitions of social good, as managers of such portfolios buy shares of some oil refiners, mining giants and nuclear power companies but not others.
The logic in choosing to invest in BP PLC and Valero Energy Corp. over Exxon-Mobil Corp., or in Adidas AG over Nike Inc., for example, varies widely and goes to the heart of why socially conscious investing strategies and analytical tools demand rethinking. Other improvements, too, are needed to facilitate comparisons, validate performance statistics and address baby boomers’ needs for fair returns and tax efficiencies.
Advancements in these and other areas will make a good thing better.
The nature of large companies complicates socially conscious investing.
They inherently have many conflicts and are forced to make compromises and trade-offs among competing interests, all of which makes slotting these companies into “good” or “bad” silos an exercise in arbitrary, if not false, choices.
Nuclear riddle
Are companies that produce nuclear power good or bad from a socially conscious investing perspective?
Nuclear plants generate electricity without emitting greenhouse gases. But they also produce radioactive wastes.
How does an asset manager decide if nuclear energy companies are suitable under socially conscious investing criteria?
This gets to the issue of screening and preferencing. Traditional screening for such investments arguably has an inherent negative bias and may overweight environmental, social and corporate-governance considerations compared with other financial indicators.
That tends to make the process exclusionary, concentrating heavily on what companies are doing wrong.
Some investors think that their portfolios should include companies that must change, using their clout as shareowners to press senior management to adopt sustainable business approaches. Not investing in polluters does little to compel them to use renewable, clean energies.
The pressure on social investing portfolios to achieve a beta comparable with those of such popular benchmarks as the Standard & Poor’s 500 stock index means that social funds include companies that are involved tangentially in socially conscious activities.
Atop such portfolios’ rosters are many technology stocks, including Cisco Systems Inc., Intel Corp. and Microsoft Corp., and banks such as Bank of America Corp. and Wells Fargo & Co. For some social funds, the cumulative investment portfolio is virtually identical to the S&P 500.
Focusing on “pure plays” in solar energy and organic foods provides an alternative approach, albeit at the cost of diversification.
One Brussels, Belgium-based analyst insists that more fundamental change is needed, specifically greater emphasis on the long term, the perspective of sustainable analysis, rather than on the short term.
More opportunities for “cross-fertilization” between sustainable and traditional analysis are needed, in his view. But what should those be?
Screening also is hampered by the difficulties inherent in quantifying environmental, social and governance factors. Data points may not be readily obtainable.
Opaque corporate disclosures may obstruct data gathering. Asset managers have made great strides in becoming more sophisticated in their screening methodologies and philosophies, and in producing better research.
But standardization of socially conscious investing criteria and performance measurements is one much-needed step forward. “With different definitions of [socially responsible investing], market factors, cultural concerns and methodologies for collecting data, it is difficult to make controlled comparisons on a global scale,” the Social Investment Forum notes.
Witness the conflicting conclusions in assessing whether investors sacrifice returns for ethical investments.
According to Morningstar Inc., the Chicago-based mutual fund research firm, socially conscious domestic-equity funds had an average annualized return of 8.53% over the past three years, while the S&P 500 gained 10.32%. By stretching that period to 10 years, which includes the dot-com boom, this gap narrows, largely because of social funds’ tech holdings — a 7.21% gain on average each year versus 7.93% for the S&P 500.
A study by the Wharton School of the University of Pennsylvania in Philadelphia over a longer period shows social funds underperforming a broader universe of funds.
Other research, though, finds that such funds neither underperform nor outperform traditional ones in terms of risk-adjusted returns.
This is the case according to work that won the forum’s Moskowitz Prize and to studies of experiences in Australia, Canada, Germany, Japan and the United Kingdom (see sristudies.org.).
Obstacles on the path
The path to standardization faces obstacles. Translating sustainable analysis into cash flow forecasts, for example, varies from issue to issue and sector to sector.
A “one size fits all” methodology is challenged further by proprietary analytics and culturally rooted definitions. Conflicts over semantics are intense, hampering mainstream uptake.
That said, though, investors need widely agreed upon benchmarks to evaluate options and to make informed choices.
Some dismiss the performance issue as being off the mark, if not irrelevant.
Socially conscious investing methodologies shouldn’t be differentiated as “extrafinancial” in the analytical framework a portfolio manager uses, as these issues ultimately have financial consequences that may influence asset and liability valuations, among others.
Furthermore, social funds shouldn’t be burdened with expectations of beating the market when most mainstream fund managers consistently don’t do so. Finally, if socially conscious investing assessments eventually become seamlessly integrated into financial analysis, the socially conscious investing distinction will become extinct.
Another complication: How does one independently confirm proprietary analysis? More work is needed to develop objective, comprehensive and verifiable processes that allow investors to compare companies’ environmental, social and governance performances.
Lower costs, better returns, greater tax efficiencies — managers of socially conscious funds will hear more of these mantras as the financial needs of baby boomers escalate in preparation for retirement. Boomers want to invest in companies that are addressing global climate change and helping achieve healthier living — but not pay more or earn less in the process.
The challenges in moving socially conscious investing to the next level are akin to those facing businesses seeking to prosper while benefiting our environment, society and investors. The groundswell of capital into social funds provides the momentum for innovation.
James D. Spellman runs a strategic communications consulting practice in Washington and is an adjunct professor at George Washington University there.