2020 Saw Upswing of Interest in Socially Responsible Investing

Sustainable and socially responsible investments have drawn a huge inflow of investor money in the past decade and COVID-19 has generated even more interest. According to a report by CNBC on a Morningstar study, $250 billion had been invested in the U.S. in so-called ESG funds by the third quarter of 2020. While U.S. investors lag European investors, about 20% of the investment in these funds comes from the U.S.
Since mutual fund companies are happy to provide what investors want, the variety of mutual funds in this area has expanded from about 100 in 2010 to more than 303 at the end of 2019.

While the majority of these funds have focused on the U.S. equity sector, it’s now possible to choose bond funds and international funds as well.

Socially Responsible, Sustainable, Impact Investing —What’s the Difference?

The moment you start scrutinizing socially responsible investments, you’ll discover there’s a great deal of difference in what the terms mean, and how fund managers establish and interpret guidelines in their selection of what to purchase.

Socially responsible is perhaps the oldest term, and generally considers three areas: environmental (including green energy, waste management and climate impact); social (including labor relations, community impact, diversity and customer satisfaction); and governance (corruption, management and board composition, compensation and lobbying). ESG focuses more on avoiding bad than specifically doing good, so you will see funds that avoid alcohol and tobacco companies, defense and armaments manufacturers, nuclear power, fossil fuels, gambling and companies that operate or invest in some nations.

Beyond that, it gets murkier, particularly in the area of labor relations. Apple, Amazon and Walmart are held by many ESG portfolios, but many people are troubled by their labor relations policies. Portfolios often contain banking and financial corporations that have made headlines for deceptive consumer practices and drug companies cited for outrageously overpriced drugs. Would you be comfortable with giant food companies that promote junk food? Once you eliminate some categories, you tend to get portfolios comprised of tech­nology, consumer products, health care, and banking and finance.

Sustainable is a newer and sometimes more specific focus, with more emphasis on environmental impact. Morningstar has adopted this term for ESG considerations as well, and now provides a guideline sustain­ability rating for mutual funds and exchange-traded funds compared to others in the general category. In other words, their sustainability index doesn’t rate a fund compared to all mutual funds, just to others in, say, the U.S. large-cap category. You might be surprised to discover that some funds that call themselves ESG or sustainable in fact score poorly in Morningstar rankings.

In addition to an overall sustainability score, Morningstar will allow you to view the score for each individual component. If, for example, the social score is more important to you than the environmental score, you can see that broken out. In addition, if you want to focus even more on environmental impact, Morningstar offers a carbon score.
Impact may actually be closer to what investors are seeking when they choose ESG investments. Rather than just avoiding negative action, impact investing attempts to choose firms that are actually taking positive action in one or more of the ESG areas. Here, too, you’ll need to look at the holdings of the fund and see if you agree. For example, Tesla is often included as a holding, but not all investors would consider their safety practices to be positive.


Criteria for Evaluation

By now it’s probably clear that selecting an ESG mutual fund is a bit more complex than picking an S&P 500 index fund. You’re going to need to look at the holdings to see if you can accept them. It’s not going to be perfect and probably every one of us will object to some of the holdings. But is it good enough for you? Does it have more of the kinds of companies you’d like to invest in? Are you more comfortable with the holdings than you might be with a generalized index fund?

Next, this is a type of investing where you really do need to drill into the fund prospectus to identify criteria used by the fund manager, usually identified as “social screens.” Some exclude companies (for example, those focused on women’s health and abortion access) that many socially conscious investors may actually favor. Also, some ESG oriented funds have a religious basis (e.g., Ave Maria, Amana), which you should identify if this is important to you.
Recognize that many of these funds, although they may contain similar holdings, have widely varying management expenses. The ones that identify themselves as “index” may have very low fees — e.g., 0.15%. Ones with a more active and precise screening process are essentially active management, and fees can be expected to be higher, 0.99%, for example.

Finally, investing means attempting to grow your money. You may be content to make a little less if you’re more comfortable with the holdings, and may wish to encourage companies to feel held to a higher standard. But an ESG fund should still be expected to perform well. Be sure to compare the fund’s performance to the broad category, as well as to other possible ESG funds. Many of these funds have a short history, so when possible, scrutinize the longest
time periods available as well as short-term performance (especially in downturns, where some pundits feel they survive better).


What Type of Investment

It’s possible to do a diverse asset allocation using only ESG identified funds. They’re available for all sizes of equity, international developed and emerging, bonds, real estate, growth or value. Whatever diversification you want in your port­folio, you can find an ESG fund that concentrates on it. When-ever we diverge from the broad market, however, it’s important to understand the different performance levels we might expect under different market conditions, and compare the potential investment to its specific category, such as real estate, as well as broader market indexes. We can also expect higher fees for more complex asset categories. Emerging market investments are generally more expensive to identify and manage than U.S. bond funds.

It’s important to note that you’re not giving money directly to ESG companies through your investment. Investments held in mutual funds are almost always purchased on the secondary market. Of course, a company whose stocks are rising will have a better reputation to raise future capital, but you’re not making a direct investment. And while you can certainly find funds that aim for impact investment in their selection, impact investing may be better implemented by purchasing individual stocks, albeit much riskier.

Another Direction

Before or in addition to investing, you might want to consider whether your “action dollars” would be better allocated directly to charities. Many social priorities are simply not profitable. Perhaps contributions to advocacy organizations, microfinance and environmental and social service charities would provide more impact than trying to identify investments.

Be careful of microfinance and peer-to-peer lending. If it seems too good to be true, it is. Do some web searching for reviews before you commit.

But if you just don’t want to make money off of evil enterprises, ESG funds are worth a critical look. They don’t have to be your entire portfolio, but you can certainly allocate some portion to profitable but responsible investments.

This article was originally published in the March 2021 issue of BetterInvesting Magazine.

Danielle L. Schultz, CFP, CDFA, is a fee-only financial adviser with Haven Financial Solutions, Inc., based in Evanston, Illinois. She can be reached at www.HavenFinancialSolutions.com.

Other Resources

September 2020’s BetterInvesting Magazine includes Phil Spinelli’s “Member Viewpoint,” an excellent article on ESG concerns. Also, my “Fund in Focus” for September 2017 is on DFA’s US Sustainability Core.

I suggest you evaluate whether charities are well-run in the way you would any investment of your money. Check out CharityNavigator.org to look at how much goes to the charity’s purpose and how much goes to administrative expenses.

These funds are mentioned for educational purposes only; no investment recommendations are intended. The author and some of her clients may have positions in some of the funds mentioned in this article.

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