Fortunately, avoiding “bad” companies is not the only way to practice SRI. The discipline has evolved to include “positive” screening, through which investors seek “good” companies; shareholder activism, through which investors try to effect change instead of just passively holding shares; and community development, through which investors inject capital into regions or causes that otherwise would be starved for it. Screening, both negative and positive, is still by far the most prevalent form of SRI, but shareholder activism and community development are growing rapidly. According to the Social Investment Forum, of the $2.3 trillion in total SRI assets in 2005, 68 percent was based on screening, 26 percent on shareholder activism, 5 percent on screening and activism, and 1 percent on community investing.
Positive screening addresses some of the shortcomings of its negative counterpart, but it also creates a few of its own. Positive screeners do not exclude whole industries but instead search within them to find the notably responsible companies. The Dow Jones Sustainability World Index, for example, screens 2,500 of the world’s largest companies to find the top 10 percent based on multiple social, environmental, and economic criteria. The criteria vary by industry, and include such factors as climate-change strategies, energy consumption, corporate governance, labor practices, and stakeholder relations. The index consists of a broadly diversified global portfolio, and its performance has been similar to one (but not all) of the major unscreened indexes in the eight years since it was introduced.
The methods for choosing “good” companies are still highly subjective. Screening criteria must be selected and ranked in terms of importance, and each company must be scored on dozens of complex attributes, often using imperfect or incomplete information. (Did you visit that factory in Vietnam to make sure your favorite sneaker maker isn’t employing 4-year-old slaves, or did you just take the company’s word for it? Did the company visit every one of its suppliers’ factories? How do you know?) The inherently subjective judgments, combined with the reality that most companies are sinful in some areas and saintly in others, lead some observers to call such rankings absurd. Warren Buffett is one. “I don’t know how I would rate Exxon versus Chevron versus BP,” the Los Angeles Times recently quoted him as saying. “It’s very difficult to judge the actions of companies that act on thousands of things every day … It’s ridiculous when people say one major oil company is more ‘pure’ than another.”
Another challenge of positive screening is that beauty may be only skin-deep. As corporate social responsibility has gone mainstream, companies have spotted a juicy marketing and PR opportunity, and corporate America is now falling all over itself to show how enlightened it is. This has made the screening process even more difficult, requiring investors to dig deep. Don’t fall for those heartwarming hybrid ads until you’re sure the car company isn’t also lobbying against emission reductions.
Most large SRI firms use both positive and negative screens, but their choices vary so much that what they do is less about “socially responsible investing” than about their managers’ personal preferences. The social-research firm KLD, for example, targets tobacco, booze, weapons, gambling, and nuclear power, and then winnows the surviving companies with a responsible-practices screen. The mutual-fund company Calvert is open to nuclear power in some cases, but always abhors gambling. And the my-SRI-is-holier-than-yours crowd doesn’t hesitate to bash firms with different priorities: Domini Social Investments gets criticized for not axing companies involved in abortion and porn; Calvert has been dissed for tolerating companies that move production overseas. (To anyone who has a basic understanding of economics and isn’t running for office, this last criticism is ridiculous. Companies have been outsourcing forever—and must, if they want to stay competitive. Our economy, meanwhile, has always created more jobs than it has lost.)
The next major category of SRI, shareholder activism, is more promising than any form of screening, at least for big institutional investors. According to the Social Investment Forum, about a third of today’s SRI investors (institutions and mutual funds rather than individuals—unfortunately, it’s hard to try this at home) seek to influence the behavior of companies through either formal proxy votes or informal talks with management. Forcing change through the proxy process is difficult. The time and expense required, combined with the tendency of most investors to rubber-stamp management recommendations, means that most shareholder resolutions fail. Sometimes just the threat of a proxy fight is enough to prod managers into constructive talks. But the threat will be taken more seriously if you own 3 million shares than if you own a few hundred. (This isn’t always true. A “dissident” Yahoo shareholder named Eric Jackson recently used a combo of moxie, marketing, and social networking to embarrass Yahoo’s overpaid, feckless managers, and he may have played a part in Yahoo CEO Terry Semel’s departure. Jackson has since trained his Internet flamethrower on Edward Zander, the CEO of Motorola. A few more successes, and he might launch a new era of shareholder democracy.) A 2004 rule requiring mutual funds to disclose their proxy-voting records has prompted even traditionally passive investors to get more active, lest they be publicly shamed for supporting egregious policies.
Unlike mere screening, activism has in some studies been shown to help deliver superior returns. Some large investors have taken an even more aggressive stance, making activism part of their investment processes. Calpers, California’s public-pension system, is a notable example. A professor at the University of California at Davis, Brad Barber, studied the returns of companies that Calpers targeted for shareholder activism from 1992 through 2005, and found that on the day they were added to the Calpers “focus list,” the firms outperformed the broader market. Barber estimates that over the 14 years of his study this superior (very) short-run performance created a total of $3.1 billion of additional market value. That sounds great, but you need to understand what it means. The day Calpers published its annual list of target companies, the stock prices of those companies jumped, as other investors read the names and immediately placed buy orders. Whether the buyers bought because they expected that Calpers’s activism would create long-term value or because they thought that the announcement would drive up the price is impossible to determine; the answer is probably both. Because these gains came only on the day the Calpers list was published, ordinary investors would have had to be paying very close attention to capture them. Meanwhile, the incremental long-term returns that have accrued so far are hard to link definitively to Calpers’s activism. The good news is that Barber believes that the long-term returns of activism like this could be enormous.
Like screening, shareholder activism has problems, one of which is free riders. Calpers is a massive asset manager—responsible for a total portfolio of nearly $200 billion in 2005—and it collectively owns about 0.5 percent of the U.S. equity market, according to Barber. As a result, the value it creates through shareholder activism accrues not only to its own shareholders but also to the great lazy majority of investors, who get additional returns for nothing. Of the $224 million a year in short-term gains that Barber says the pension system has generated through its activism, he estimates that only $1.12 million a year accrued directly to state employees whose retirement savings are managed by Calpers. The rest went to couch potatoes, hedge funds, and other slugabed tagalongs, some of whom no doubt bought the pension system’s “focus stocks” the day the list was released and jubilantly flipped them the next. The gains for Calpers translate to only 0.07 percent of incremental performance on the fund’s portfolio. Although the pension system’s activism may help the companies it targets as well as those companies’ other shareholders, Calpers itself won’t benefit if the cost of its activism exceeds its gains. This is an unfortunate paradox that is, or should be, important to most asset managers.
Significantly, Barber draws a distinction between efforts by Calpers to improve corporate governance and shareholder rights, and its occasional forays into more-traditional SRI concerns—dropping tobacco stocks from its portfolio, for example, has cost Calpers $633 million so far. Its screening efforts, in Barber’s opinion, also create a conflict of interest between its management and its investors—the state employees, who may have different social priorities (the “eye of the beholder” problem). If institutions want to avoid “bad” companies, Barber says, they should make sure their shareholders agree that the companies they single out are bad. They should also make sure that their screening decisions have been empirically shown to improve investment returns—which tobacco-company elimination most emphatically has not.
The final category of SRI investing, which encompasses only 1 percent of SRI assets, is community development. Here the goal is to direct capital to underserved communities via banks, credit unions, loan funds, venture-capital funds, microfinance, and other vehicles. Though still small, community-investment efforts, according to the Social Investment Forum, have helped Native Americans buy back ancestral lands and start businesses, restored salmon and trout to the Chinook watershed in Washington state, created affordable housing and high schools in Boston, provided microfinancing in Bangladesh, and funded AIDS prevention.