The theme of using one’s money for the good of society dates to the early days of life here in America. As a young investor in the 1990’s, I learned that socially responsible investing involved the avoidance of sin stocks, which were a grouping of companies in the alcohol, tobacco, gambling, firearms, and defense industries. The implied social benefit then was to support only socially responsible companies at the expense of those in sinful industries. We did not know it at the time, but the selection or disqualification of investments based on ethical concerns was the starting point for socially responsible investing (SRI). Over time, a heightened public focus on issues like climate change and environmental sustainability has fueled the popularity of SRI, especially with younger investors who look to invest in companies that maximize the perceived societal impact of their capital. The concept then and now is sound and leaves us with just one question to answer. As investors, will we sacrifice performance to invest with our conscience?
Today, while the terms SRI and ESG (Environmental, Social and Governance) are often used interchangeably there are important differences between the two strategies. SRI, with its narrower focus, is both different from as well as a subset of ESG, which itself has a broader view of potential investments. An ESG review supplements traditional financial analysis by identifying a company’s ESG risks and opportunities. Nonetheless, with ESG investing financial returns remain a primary objective. Today, investors can choose from over 750 mutual and exchange traded funds (with total assets over $2.5 trillion) if they would like to add a social responsibility component to their portfolios. The focus now is not only on the exclusion of sin stocks, but also on including companies that promote and adhere to high standards in environmental, social and governance (ESG) functions as a means of doing business. We think ESG is a better choice for most investors.
The MSCI KLD 400 Social Index (KLD) “is a capitalization weighted index of 400 US securities that provides exposure to companies with outstanding ESG ratings and excludes companies whose products have negative social or environmental impacts. Companies are chosen for inclusion in the index based on ESG performance, sector alignment and size representation.” Environmental categories often include climate change, natural resource use, water sustainability, reduced carbon emissions, global renewable energy solutions and waste management. Social categories include human rights, labor relations, product safety, community impact and workplace health and safety. Governance categories include ethics, shareholder rights, executive compensation, board independence and corporate transparency and disclosure. On the matter of investment returns, when viewed over 1-year, 3-year and 5-year periods, the performance of KLD is generally in line with that of the S&P 500. Is it possible that an investment in an index comprised of socially responsible companies could provide the same type of investment return as the broader market? Of course, it is. Can a firm’s impact on the environment and social welfare positively affect its brand and ability to seek long-term profit maximization. Yes, again. May be the answer lies in the fact that companies with the highest ESG criteria score might also be the best run and most profitable companies.
The correlation of investment returns and social impact is open to much debate. Is it reasonable to expect that their future relationship can be mutually inclusive? It depends on who you ask. None other than famed investor and Berkshire Hathaway CEO Warren Buffett once questioned the wisdom of chasing both profit and social good together when he stated, “I think you should make the most money you can and then use that for whatever social or philanthropic goals that you may have.”