The challenges of being a socially responsible investor

“Socially responsible investing” has become a big business in the investment world. As it has grown in popularity with investors and become more available through an increasing number of funds, the terms we use to refer to this investment approach have evolved. What used to be known as “socially responsible investing,” or SRI, is now more often referred to as “ESG” or “sustainable investing.” When the language used to describe something is unsettled, it tells you that the thing itself is unsettled and still evolving. Such is the case with socially responsible investing. It is an approach that is still evolving and, as we will see, it presents some challenges for investors who want to adopt a “do-good” or purposeful approach to investing.

There may be subtle differences among the three iterations — SRI, ESG and sustainable investing — but all three describe an approach to investing that focuses on non-financial considerations. For ease of reference, we are going to refer to ESG in this discussion.

ESG is an approach to investing that goes beyond the conventional emphasis on financial considerations to include an assessment of the societal value of an investment. Conventional investing focuses on the expected return of a security and weighs that against the expected risk. Conventional investing relies heavily on fundamental analysis to assess the value of a security. Fundamental analysis considers a host of economic and financial factors relevant to a particular company with the aim of determining a security’s intrinsic value and then deciding whether to buy or sell based on whether the security is over or under valued in a financial sense.

ESG does not necessarily ignore fundamental analysis. No one wants to own a bad financial investment. ESG tries to identify securities that are good in other ways and it does this by using a more expansive notion of value. ESG ascribes value to certain moral or ethical principles or to certain policy objectives and then tries to identify “good” companies that align with those values and avoid the “bad” companies which don’t.

ESG investors want two things beyond acceptable investment returns: 1) they want investments that reflect their values or, at least, do not offend them, and 2) they want to change corporate behavior to be more aligned with those values.

On its face, these are laudable aims, but not everyone would agree. The economist Milton Friedman argued, “There is one and only one responsibility of business: to use its resources and engage in activities designed to increase its profits.” Friedman was much criticized for this statement, but Friedman qualified his statement by adding, “… so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.”

Even that qualification is not enough to satisfy some ESG proponents. A full exposition of Friedman’s position is beyond the scope of this short discussion, but in fairness to Friedman it should be noted that he did not believe that corporations could not or should not do “good.” It would be fairer to say that he believed that corporations doing well financially by itself has societal benefits and that no corporation will be able to do anything for long if it is not profitable. In the not-for-profit world, there is an expression: “no (profit) margin, no mission.”

Putting aside whether companies should prioritize aims other than profitability, investors who wish to be socially responsible in their investment selection have several practical challenges to consider. Here are three important ones, but this is by no means an exhaustive list of the challenges investors face.

1. What is “good” corporate behavior and who gets to decide? Assessing a company’s alignment with moral, ethical or policy values is a far more subjective undertaking than is determining the intrinsic value of its shares. Different investment managers will identify different priorities and reach different conclusions even if they all share a broad common goal such as identifying companies which are good environmental actors.

If, for example, reducing carbon emissions is the greatest environmental good, then should nuclear power with a low carbon footprint be considered more favorably? Should energy efficiency or pollution mitigation be considered better measures of good corporate behavior because they have a more direct and immediate impact on the lives of people than does a company’s carbon footprint? Is a tech company a better company from an environmental perspective than a company that engages in heavy industry simply because of its lower carbon footprint? What about the environmentally unfriendly methods used to extract the rare earth minerals needed for many high tech devices? How is that weighed in the balance? These considerations all involve judgment calls.

Someone has to identify the desirable corporate priorities as well as determine their relative importance. Increasingly, these judgments of selection and ranking are being heavily influenced by a handful of large investment companies such as BlackRock and State Street. Some ESG advocates go as far as to argue that broad social justice priorities should be defined and made mandatory through law.

To properly understand the priorities of an ESG investment and to determine whether the investment truly aligns with their values, investors need to look beyond ESG marketing materials.

2. Is the data reliable? There are currently hundreds of funds with an ESG mandate of some sort, not to mention many other ESG style investment portfolios. The growth in this style of investing has necessarily led to the growth of firms that issue ESG ratings. Fund managers may rely in whole or in part on such ratings to assemble a portfolio and investors may rely on such ratings when evaluating a fund. Recent studies indicate that the rating firms do not always use a consistent set of criteria to measure or rate compliance with ESG objectives. This makes it difficult to draw comparisons. For example, different rating firms may define broad environmental, social or governance objectives differently; or they may use different metrics to measure compliance with those objectives. And even if they use the same or similar metrics, they may assign different weights or relative importance to those metrics. All of these factors lead to a lack of consistency of the ratings and potential confusion for investors.

3. Is performance sacrificed? Most ESG style funds underperform their appropriate market benchmark over the long term. That should not be a surprise. ESG funds are mostly actively managed, meaning the fund manager is making a deliberate decision to own a portfolio of stocks that is different than the composition of the broad market, and we know from years of data that most actively managed funds underperform their market benchmark over the long term. ESG investors should determine by how much their “do-good” fund underperforms and whether the trade-off of lower returns is worth being true to their values. Needless to say, not all ESG funds underperform and over the recent past many ESG funds have done very well because of heavy exposure to tech and other sectors that have recently outperformed the broad market. Still, long term performance is a challenge, and it is difficult to impossible to know ahead of time which funds will underperform and which will outperform.

It is easy to understand why ESG investing continues to grow in popularity. But investors who want to make this part of their approach to investing need to look closely at whether: 1) the value of the fund truly matches their own values and objectives, 2) the data allows for reliable comparisons among the various ESG alternatives, and 3) there is a trade-off between performance and doing good and, if there is, whether the trade-off is justified.

In this respect, ESG is no different than any other approach to investing: Let the buyer beware.

David Peartree JD, CFP® is a registered investment advisor offering fee-only investment and financial planning advice. This column is a collaborative work by David Peartree and Patricia Foster, Esq. Patricia Foster is a securities law attorney whose experience includes representation of clients in various sectors of the financial services industry, including, broker-dealers, investment advisers, and investment companies. This article is provided for educational purposes and does not constitute investment advice. You should consult with your own tax or investment advisor.