The term “Socially Responsible Investing,” or SRI, has been around since the 1970s when the public applied pressure on pension funds to divest of companies involved in controversial activities. For example, during the Vietnam War there was pressure on pension funds to avoid Dow Chemical because the company was profiting from the war. During the apartheid government in South Africa, public pressure to divest of companies with operations in the country is seen as having played a role in ending the apartheid reign. Popularity of SRI grew in the 1980s, and with the proliferation of mutual funds came two SRI mutual fund families, Calvert Funds and Pax World Funds. Despite the ability of the public to invest in a socially responsible way, it remained a niche market in the investment world. One of the biggest impediments to wide-scale adoption of SRI has been the common belief that limiting investments to socially responsible companies would result in subpar investment performance. The other problem with SRI is that it employs what is called a “negative screen,” meaning it specifically rules out investing in a given company or industry. Although this may work for a state pension fund that wants to avoid a handful of investments, such as tobacco or alcohol, implementing a negative screen for a mutual fund with a broad shareholder base is problematic, as individuals have many different opinions on what should be avoided.
Over the last decade, SRI has given way to Environment, Social, and Governance (ESG) Investing, or Sustainable Investing. Under ESG Investing, companies are graded on how well they score on three factors: the environment score is based on how the company takes care of the environment; the social score relates to human rights issues as well as diversity within the company’s employees, management, and board of directors; and the governance score refers to the alignment of management’s interests with shareholders’ interests and management’s relationship with its employees. To be included in an ESG-focused strategy, companies need a good overall score.
In addition, ESG investment strategies do avoid certain industries, mainly controversial weapons and tobacco. This reduces some of the implementation impediments associated with a negative screen, as the strategy can cater to a wider range of investors and still invest in companies that lead in their industries. Many investors, such as the California Public Employees’ Retirement System, take this a step further and focus on the most important factor for a particular industry. For example, in manufacturing and energy organizations, environmental issues are the biggest concern because a company that can run efficiently and minimize its impact on the environment has a brighter future than a company that lags in this department. However, environmental issues have very little impact on the sustainability of a bank, which should focus on the long-term well-being of its employees for business success. Therefore, social and governance scores are more important factors to consider when investing in that industry.
We are excited to offer ESG Investing options at HC Financial. ESG Investing is still fairly new and many of the fund offerings, outside of a few pioneers, have limited track records. We do feel, however, that this trend is here to stay, and we want to offer clients the ability to participate, if desired. Individual stock portfolios are the best way to customize portfolios for clients who would like to avoid specific industries. Although we don’t currently use an ESG screen for individual stock holdings, we are happy to report that almost all HC Financial individual stock holdings pass an ESG screen. We have also assembled a list of ESG mutual funds that can be used in portfolios, both in the core large capitalization U.S.-based companies and the small capitalization and international investments.
Running back-tested data for the past four years, we have found almost no difference in the risk or return for a portfolio of the best ESG mutual funds compared to the current mutual funds we are using. The two major caveats we would point to in implementing an ESG mutual fund portfolio are the following:
Compared to many of our current holdings that have decades of risk and return data to rely on, many ESG funds are new with limited track records. This is the reason we could only test data for the previous four years.
ESG Investing does not exclude many industries you may wish to avoid. For example, an energy company such as Exxon has a track record of investment in oil well safety yet still earns an average score in the environmental factor. However, its diverse board of directors and workforce give it very high marks in governance, meaning that many ESG portfolios include Exxon. For clients looking to avoid specific industries, a portfolio of ESG mutual funds may not be particularly effective.
If you are interested in moving toward an ESG strategy, please let your advisor know and we can discuss implications on your specific portfolio and tax situation.