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Socially Responsible Investing: Risk and Return

By Chris Chen, CFP®, CDFA®

It makes sense that in the growing number of conversations I have with investors around how to reach their personal financial goals in a more positive, responsible or impactful way, we eventually come to the question, “What does it do to the return on my portfolio?” Many assume it could limit return, partially because there is a lot of misleading information out there, but also because there is a need to understand how the area has evolved into a very dynamic and innovative financial process.

Knowing what to even look for over the years has been confusing for investors with varied terms ranging from socially responsible to impact investing. I find the entire space is best defined under SRI (sustainable, responsible and impact) investing. And for us individual investors, it can be our singular most powerful way to make a difference and contribute to the causes that are important to us. (For more, see: Go Green With Socially Responsible Investing.)

The Return and Risk Factors

But when we are also concerned with growing our own personal wealth in the process, the return/risk factors around SRI are important parts of the equation. Because aside from all of the positive impacts SRI can have, we find it can provide real tangible advantages to improving your portfolios performance.

How SRI typically works with investments we are most familiar with like mutual funds, exchange-traded funds (ETFs), stocks and bonds is by expanding the investment analysis process to include financial metrics and additional measures in areas of environment, social and governance (ESG). It results in a more detailed assessment of long-term return potential and more thoroughly examines areas of risk. It makes the entire process more complete, dispelling the popular myth that SRI is trying to be a substitute for financial analysis.

One easy way to use this information with the most popular form of investing, mutual funds, is through Morningstar. A well-recognized leader for their mutual fund analysis, they teamed up with a sustainability data provider called Sustainalytics in 2016. Together they created a system to help individual investors easily evaluate ESG measures with one, easy to understand sustainability score. When combined with their financial rating system it can be a very effective way to select top financial SRI performers.

Impact Investing

The “impact” area of SRI offers even more alternative and innovative ways to achieve a financial return while also giving you a direct link to helping a specific community or cause. Two of the more popular forms would be community or microfinance funds. These types of investments are usually run by an organization (often a non-profit) that raises investment capital to be lent to communities, either locally or globally, that are impoverished or underserved. It typically gives the investor both a financial return and the ability to see their investment directly help someone in need. (For more, see: Socially Responsible Stocks: Do Good Deeds Punish Profits?)

These types of investment can have different risks than you may be used to, so you need to understand them all before considering to invest. I always strongly advise you consult with a professional who knows impact investments before getting started. However, they can provide additional financial benefits and it can be very personally rewarding to be able to physically see what good your investment has done.

For investors that want to focus on solving a particular problem like climate change, or supporting a certain cause like gender equality, there are a variety options available. One example I like is the Pax Ellevates Global Women's Index Fund because it emphasizes investing in companies that invest in women. Pax not only sees the need for an important social change, but recognizes that gender equality is critical to business success and can enhance investment performance. This fund consistently ranks near the top of its category. Having a basis in how SRI can work and what options are available can help lay the foundation for you in knowing how it can improve your financial performance.

Enhancing Portfolio Performance

The basis for any evaluation of investment performance consists of measuring two main elements: return and risk. There are varying degrees of correlation between the two within assets classes, economies, sectors and even investment types. But the ultimate goal of reaching optimal performance is achieved by maximizing return while minimizing risk. Every investor has to balance the risk they are willing to take with the return they need to achieve their personal goals. This begins with the process of portfolio building and asset allocation. But once you get down to the level of comparing investment to investment, SRI can offering an interesting edge especially in risk.

Think about an example of two large-cap mutual funds, where one only applies traditional analysis of financial risks. While the other large-capital mutual fund evaluates those same financial risks, it then goes further to evaluate a corporation’s potential for a negative environmental impact exposing them to higher regulatory, legal or operating costs. Or it considers certain social risks, such as companies that have a history of poor diversity, or unfair treatment leading to high turnover or inability to retain or attract top talent. Or it may look at the how the company’s governance reflects large pay disparities between management and employees or other unethical behavior leading to public relations disasters or boycotts potentially killing the company’s profits. (For more, see: Socially Responsible Investing: How Millennials are Driving It.)

All of these factors can dramatically affect their stock price, becoming incredibly important to our understanding as investors. It just follows along the logical path of using greater analysis and gives us more information to make better investment decisions about how to avoid risk and choose better long-term investments.

Greater Diversification Potential

One of the best ways to reduce risk in your portfolio is through diversification. The beginning stage is done by spreading your money across stocks, bonds and cash. However, more sophisticated and wealthy individuals will often add greater diversity by including investments in commodities, private placements, hedge funds and other alternatives to try to get an advantage on the market. Each of these areas can be incredibly risky on their own but done in the right way, they can help offset risk in other parts of their portfolio.

Certain SRI investments offer this same level of sophisticated diversity but do something impactful at the same time. As an example, when some portion of your portfolio is in a microfinance or community investment fund, you can offset more traditional market-related risks such as the inverse relationship of interest rates and bond values, simply because these impact type of investments typically do not trade on a market and are not effected in the same way as bonds. It does not mean they do not hold risk (some of their risks can be substantial) it just means that they can offset other areas of risk in a portfolio. But when used properly they can be an intelligent way to reduce risk, gain a competitive financial return and make an inspirational change in the process.

The Personal Return

Although no investment can guarantee a financial return, SRI investing can guarantee a return that goes beyond monetary measure and most find this much more rewarding. I call it the “personal return” - the value in having your capital help another human being, community or important cause. SRI investing is an incredibly powerful way to have your money working towards your own personal financial goals while providing the means to help others, solve problems or contribute to a brighter future. It is your opportunity to use capitalism at its very best.

The SRI trend continues to grow, expand and revolutionize the way we institute change. And it gives each of us an easy way to do so within our own retirement plans, IRAs and investment accounts. You do not have to choose between your personal values and financial returns of investments because the ability to do both is there. You can get started by reviewing the resounding number of resources available to you such as USSIF (The Forum for Sustainable and Responsible Investing) or Morningstar to help you research SRI and performance.

Of course all investments can lose value and past performance is never a guarantee for future returns for any investment, SRI or not. But with the right approach there is no reason you cannot achieve the financial performance you need and live within your beliefs of making a greater impact on the world around you. (For more, see: SRI Funds and Your 401(k): What You Need to Know.)

This article was originally published on Investopedia.

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


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