Socially Responsible Investing: How to Align Your Values With Your Portfolio

Socially responsible investing (SRI), or choosing investments based on your values and morals, is becoming more and more popular, according to a recent study by the Forum for Sustainable and Responsible Investment. As of 2016, there was $12 trillion under management using SRI strategies. With one-fourth of all U.S. assets under professional management earmarked for SRI, there's clearly something going on, here.

The goal of SRI is to align investors' values with those of the companies in which they invest. When employing SRI to find ethical investments, you may screen out sin stocks like companies involved in selling alcohol, tobacco, or firearms. It could also mean finding companies that focus on environmental issues by promoting green energy, using sustainable water sources, or lowering their carbon footprint.

A successful SRI strategy creates a win-win-win situation: Investors support the causes they believe in, companies attract the funds they need to grow while their operations benefit from sustainability efforts, and ultimately, society benefits, too. If this appeals to you, there are a few ways to develop a knack for SRI. 

Middle-aged couple hugging and smiling outdoors

Socially responsible investing is a way to do good and feel good about your investments. Image source: Getty Images.

What is SRI?

SRI is not new, but it has evolved and gained traction. Pioneered by mutual fund companies in the 1970s and 1980s, there are now 395 mutual funds that Morningstar identifies as socially conscious.

Along with this growth, the original socially responsible investment (SRI) approach has inspired two new offshoots. ESG investing refers to mutual funds and investment strategies that integrate certain environmental, social and corporate governance considerations into their selection process. Environmental issues include pollution or waste production, social themes include human rights and child labor, and corporate governance refers to how the company is run including the quality and independence of its board of directors. While SRI and ESG may overlap, think of ESG as less restrictive. An ESG screen will rank companies based on their list of factors including potential for financial performance. The higher the ranking, the more likely the investment is considered. ESG may consider companies that a SRI strategy excludes. A strictly SRI strategy eliminates a company if it doesn't meet its socially responsible definition, regardless of expected financial performance. 

Another newcomer to this arena is "impact investing". With impact investing, a positive outcome is what matters most. The goal of impact investing is to help a company or organization accomplish a specific goal that will improve society or the environment, for instance -- investing in an energy company with a mission to produce green energy to power homes. The result or outcome is what matters most, and there may be no upfront screen for social or moral issues like in a SRI strategy and no financial expectation like in a ESG screen. If you had to rank the three strategies from most selective to least, it would be SRI, ESG, and impact investing. 

How has SRI performed?

The performance of the Vanguard FTSE Social Index Fund (NASDAQMUTFUND: VFTSX), which seeks to "track a benchmark of large- and mid-capitalization stocks that have been screened for certain social, human rights, and environmental critieria" has been quite good. At times the Social Index fund has done better than the S&P 500, and when it underperformed, it wasn't by much. (Of course, past performance is no guarantee of future results, but going back 10 years is a long enough track record to fairly compare.) On the whole, shown by the below table, investors in Vanguard's Social Index fund haven't underperformed as much as one might expect -- in fact, it's been quite the opposite:

Over the Last... VFTSX Performance S&P 500 Performance VFTSX Overperformance
1 year 13.74% 12.37% 1.37%
3 years 15.72% 14.32% 1.40%
5 years 11.80% 11.25% .56%
10 years 16.10% 15.27% .82%

Data source:; data as of 04/09/2019.

Building a socially responsible portfolio

There are more choices than ever for socially responsible investors. The first option is active mutual funds. Mutual fund companies Calvert, Pax, and Parnassus are the big three in SRI, but there are more choices today with fund companies like TIAA-CREF, Brown Advisory, and Neuberger Berman all offering actively managed SRI mutual funds.

There are also exchange-traded funds (ETFs) that align with SRI. Most notably, ETFs have embraced the newer concept of ESG investing. BlackRock, a leader in ETF investing, offers several types of ESG ETFs including funds that track an index, thematic ETFs that focus on a specific issue such as diversity in the workplace, and impact ETFs, that target a "measurable sustainable outcome alongside a financial return."

If a broad passive index is more your speed, unfortunately, the Vanguard FTSE Social Index Fund recently closed to new investors, but there is the iShares MSCI KLD 400 Social ETF (NYSEMKT: DSI), which has been around since 2006. It has more than $1 trillion in assets under management (AUM), and tracks an ESG index.

Look under the hood

Buying an SRI or ESG fund is much like buying a regular mutual fund or ETF, meaning you still have to do your research on the financials. This includes considering expenses, track record, and management experience. Expenses drag down the fund's performance, even more so in the active management space. Index funds and ETFs usually have lower expense ratios; you can find this information by going to each fund's website or by reviewing its prospectus. Generally, an expense ratio less than 1% is fair.

If the SRI fund you're considering would be your core equity holding, you'll want to make sure its performance hasn't deviated too far from a broader index, like the S&P 500. If it has strayed far, then perhaps the fund is too risky to be your core holding; it might be better used to complement a broadly diversified equity strategy.

Experience counts in investing, and if an ETF is new, it might be wise to wait and see how it performs before buying in. Some exchange-traded ESG offerings may be more sizzle than steak. It's better to be fashionably late to this party, unless you have the risk tolerance to stomach the potential volatility. It all comes down to your asset allocation and time horizon for needing the money you invest; the more time you have to stay invested, the more you should put into stocks.

Risks to SRI

The two biggest risks faced by social responsible investors (across all arenas: SRI, ESG, and impact) are a lack of diversification, and that the performance of their investments might lag behind the market. If a fund only invests in a select group of companies, can it be diversified enough? Cutting out companies that don't fit certain social investing criteria limits the pool of companies to select from. In addition, a SRI fund may screen out entire sectors like oil and gas companies, gambling casinos, or beer and wine distributors (the so-called "sin stocks"). If that's the case, and these sectors start to do very well, an SRI-only investment strategy might underperform the broader indexes. This is where an ESG investment may benefit, since financial performance is an important factor.

For impact investors, another risk is the amount of time it could take to make money. Impact investors may have to wait longer to enjoy the fruits of their labor. Impact investors should ensure they have plenty of other liquidity to get by in the meantime, have a long enough time horizon to wait it out, and are diversified in other investments to balance out the risk. 

Putting it all together

Given all this, how does one build a SRI strategy? First, decide if you strictly want to screen out all companies that don't meet a certain moral or ethical criteria. If that's the case, then stick with a SRI strategy. If you want a compromise between performance and some social responsible investments, ESG is a good avenue to explore. Finally, who is the ideal impact investor? An investor who is in it for the end result and wants to back companies seeking to actively do good in the world.

If you want to include some socially conscious investments but you don't want them to make up your whole portfolio, then using an SRI or ESG strategy to complement a broader investment portfolio -- a "core and satellite" approach -- is a good idea. This may mean buying an ESG ETF or SRI index fund as a satellite, or smaller portion of the portfolio, along with an S&P 500 index fund as a core, or larger, equity holding. This way you get to do good and feel good, while also enjoying the diversification benefits of holding a broader index. 

Socially conscious investing is growing for good reason. Investors are more aware of the impact they can have on the world around them. In addition, socially conscious investors have been rewarded, demonstrated by the Vanguard Social Index. The newcomers of ESG and impact investing further demonstrates the popularity of this investment style. Maybe there is some serious value in creating a win-win-win. 


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Michael Aloi has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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