The Conscientious Investor

Socially responsible investing is neither as profitable nor as responsible as advertised. But if you insist, here’s how to do it right.
Tobacco fields
FIELDS OF GREEN: Tobacco has historically been one of the nation's most profitable—and controversial—products.

The goal of “socially responsible investing,” or SRI, is to make lucrative investment choices that have a positive impact on the world. SRI comes in many forms, but one of the most common is avoiding investments in “bad” companies. You, of course, are eager to be part of this pioneering movement that will help the environment and your fellow human beings—to do well by doing good. So let’s play a game.

First, if you could go back 50 years and magically eliminate one industry from the global economy to make today’s world a better place, which would it be? Oil drilling? Handgun manufacturing? Tobacco? If you’re like most socially responsible investors, you would pick tobacco—an industry whose products sicken or kill millions of people a year and disgust almost everyone else.

Second, if you could go back the same 50 years and retroactively add one stock in the Standard & Poor’s 500 to your retirement portfolio, which would it be? IBM? DuPont? Philip Morris? If your goal is to generate the highest possible investment returns, the choice would be easy: tobacco giant Philip Morris—the single best-performing stock in the S&P index for the 46 years through 2003.

And therein lies the central dilemma for most socially responsible investors: Your virtue can cost you. How much would boycotting Philip Morris’s stock have lost you over the past half century? As Jeremy J. Siegel has pointed out in his book The Future for Investors, the S&P 500 returned 10.85 percent a year from 1957 through 2003. Philip Morris, now Altria, returned 19.75 percent. Thanks to the miracle of compounding, if you had invested $1,000 in the S&P 500 in 1957, you would have ended up with $124,000 in 2003. If you had invested in every stock in the S&P 500 but Philip Morris, you would have ended up with about 5 percent less. (If you had invested the $1,000 in just Philip Morris, you would have ended up with $4.6 million—but you didn’t want to know that.)

Some of our most loathsome, socially unredeeming industries have produced great investment returns. So if you’re tempted to save the world by avoiding investments in “bad” companies, you might first test your commitment by answering a couple of questions. Assuming perfect foresight back in 1957, would you really have forgone 5 percent or so of your retirement nest egg just to avoid owning shares in one lousy tobacco company? Would you have forgone $4.5 million? Be honest. And welcome to the world of socially responsible investing.

The Social Investment Forum, a nonprofit group dedicated to promoting SRI, traces the roots of the modern practice to religion: specifically, to Colonial-era Quakers and Methodists avoiding companies that participated in the slave trade. In the 1950s, a mutual fund called the Pioneer Fund began avoiding “sin stocks”—those associated with gambling, smoking, and alcohol. The events of the past few decades—Vietnam, civil rights, feminism, the environmental movement, Bhopal, Chernobyl, the Exxon Valdez, and South Africa—brought the idea of using investment choices to influence corporate behavior into the mainstream. In recent years, a wave of corporate scandals and the sudden awareness of climate change have given the concept even greater visibility.

The Social Investment Forum’s 2005 state-of-the-industry report put the amount of investor capital that was devoted to SRI at $2.3 trillion. That is a lot of money. To put the SRI movement in perspective, however, it was only 9 percent of the total $24.4 trillion of professionally managed assets in 2005. The forum touts the impressive growth of SRI over the past decade: That $2.3 trillion had almost quadrupled since 1995, from $639 billion. But most of this growth came from market appreciation rather than a great investor awakening. The value of the S&P 500 grew at about the same rate, and 1995’s $639 billion represented the same 9 percent of total assets as 2005’s $2.3 trillion did.

The majority of today’s SRI assets, moreover, are managed by institutional investors, such as public-pension funds and religious groups, rather than by individuals. Some mutual funds, a main investment vehicle for individual investors, are dedicated to investing according to SRI principles, but not a significant number. In 2005, there were 201 SRI mutual funds, managing $179 billion in assets. This amounted to less than 10 percent of the total assets devoted to SRI, and only 4 percent of the $4.9 trillion invested in equity mutual funds. For all the press it gets, socially responsible investing is still a niche strategy—and if not for some promising recent developments, it would likely remain that way.

The first problem with labeling a particular style of investing “socially responsible” is that it suggests that other kinds of investing are not. So it’s no wonder many people find the concept silly or offensive.

At some level, after all, our very economic system is socially problematic. The benefits accrue disproportionately to owners (investors, this means you), who make fortunes off the labor of rank-and-file employees. Luck plays a role, as does timing. Education, connections, and money give some people an edge, and hard work doesn’t always carry the day. The key to increasing profit and wealth is improving productivity, and an owner’s glee at producing the same amount with 50 workers as with 100 is not often shared by those who got canned. If you’re going to invest in any free-market enterprise, you’re going to have to accept that no matter how enlightened your choices, your money will be supporting wealth disparity, inequality, and other arguably unfair conditions that go hand in hand with a successful free-market economy.

That said, all capitalism is not created equal, and investment decisions do help shape corporate behavior. If two entrepreneurs come looking for money—one who wants to burn national forests for charcoal and one who wants to power cars with seawater—the decision to finance one plan instead of the other could affect the rest of us and the planet. As a century of industrialism before the introduction of environmental and labor laws illustrated, the free market does not appropriately “price” the cost of natural resources or pollution. So the idea that responsible investment practices can be used in conjunction with intelligent regulation and consumption to serve the greater good is reasonable. The challenge comes in figuring out how best to do it. (Given my own high- profile career as a Wall Street analyst—which ended amid SEC allegations of civil securities fraud, a fine, and ejection from the industry—I have had as much cause as anyone to contemplate the moral dimensions of investing.)

In a perfect world, socially responsible investing would promote practices that improve life for everyone, not just those whose religious or personal beliefs lead them to value some products, services, and practices over others. Today’s SRI, however, has about as many definitions as it does practitioners, and not all of them serve a universal definition of “the greater good.” Peter Kinder, who runs the social-research firm KLD Research & Analytics, has defined SRI as the “incorporation of ethical, religious, social and moral values in investment decision making”—which sounds nice until you remember how much havoc different religious, social, and moral values have wrought over the years. A former chair and president of the Social Investment Forum, Steven Schueth, has a more inclusive definition: “Generally, social investors seek to own profitable companies which make positive contributions to society.” But even this raises questions. First, what’s wrong with unprofitable companies, given that almost every emerging biotech, technology, communications, and infrastructure company loses money? And, second, what qualifies as a “positive contribution to society”?

Despite the seeming ease with which tobacco companies can be dismissed as greedy drug pushers, even they do some good—providing tens of thousands of jobs, for starters. And as you move down the SRI screening list, the elimination process gets harder. Take today’s favorite SRI target: the repressive government of Sudan. Will disinvesting in any company doing business with Sudan, as many activists are calling for and many investors have already done, help stop the genocide in Darfur? Or will abrupt withdrawal of foreign capital only strengthen the Sudanese government, as other investors—including Warren Buffett—say it could?

After tobacco, the next two industries on the list are alcohol and gambling; more than half of SRI mutual funds eliminate them. Alcohol and gambling certainly cause plenty of problems. Alcohol, especially, kills, maims, screws up families, and turns customers into addicts and occasionally into murderers. (Car companies provide the vehicles for most booze-addled killings, but no SRI fund that I’m aware of screens out car companies.) On the other hand, would you really want the winery that produces your favorite pinot noir to go bankrupt? The tens of millions of people who jet to Las Vegas each year might tell their pastors that the Luxor is evil, but it’s hard to believe they (or their pastors) never intend to go back.

Companies in the weapons and defense business are shunned by almost half of SRI mutual funds. This presumably means that besides objecting to unjust wars, handgun rampages, and drive-by shootings, the funds’ customers also believe that society would be better off without armed forces or hunting. The next three criteria—environmental impact, labor practices, and product and service quality (including safety)—involve true social responsibility, so it is a pity they are so far down the screening list. Based on rankings alone, far more SRI investors avoid tobacco companies than worry about the abuse of the environment, employees, and consumers.

The rest of the mainstream SRI screening criteria focus on community impact and on workplace diversity. Human rights, faith-based considerations, pornography, and animal testing are considered “specialty-use” screens and are applied by a minority of SRI funds. Less than a quarter of funds screen on such factors as abortion, health-care/biotech/medical ethics, “antifamily” entertainment and lifestyle (don’t ask), and excessive executive compensation.

The main problem with eliminating “objectionable” companies is that “objectionable” is in the eye of the beholder. The other drawback, one that probably deters more people from pursuing the strategy than would say so, is the likelihood of lower returns. By eliminating whole industries from their portfolios, negative screeners reduce their diversification and risk losing out on gains. Not coincidentally—because free markets are, to a large extent, self-correcting—the more “objectionable” an industry, the higher its future returns may be. Bad publicity and lawsuits tend to depress stock prices, and the lower prices set them up for strong future returns. Companies can address objections to many practices by improving labeling, cleaning up manufacturing processes, revising policies, or just getting out of controversial lines of business. Once the changes have been made, their stocks often play catch-up—leaving investors who boycotted them in the dust.

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Henry Blodget, a former stock analyst, is the author of The Wall Street Self-Defense Manual: A Consumer’s Guide to Investing (2007).

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