But let’s get back to the heart of the matter. As much as SRI investors say that their goal is to support socially responsible practices, the real priority, as for nearly all other investors, is returns. One survey suggests that 80 percent of SRI mutual-fund investors would not buy SRI funds unless they produced returns equal to or higher than conventional funds. Unfortunately, these investors may be delusional. As with mutual funds, most SRI funds produce lower returns, after adjusting for risk, investment costs, and other factors, than low-cost index funds would.
After examining the performance of several indexes of socially approved stocks from 1990 through 2004, Meir Statman, of Santa Clara University, found that the returns of the social indexes were generally higher than those of their conventional counterparts, but that the differences were not statistically significant. (Translation: The performance might have been the result of luck.) The SRI stocks were also more volatile than the market overall, and this, according to finance theory, suggests that the higher returns were earned in exchange for higher risk. In any case, investors can’t buy indexes, they can only buy funds, and most socially responsible funds come with costs that basic index funds don’t: expensive portfolio managers, analysts, and research. For example, according to Statman’s study, Domini’s index of 400 socially responsible stocks beat the S&P 500 index from 1990 through 2004. But owing, most likely, to the high cost of social-investing research, the Domini fund lagged Vanguard’s flagship S&P 500 index fund. (It costs money to make sure that a chemical company isn’t dumping poison in the lake. And just because your portfolio manager is socially responsible doesn’t mean he wants to putter around town in a secondhand Ford while his hedge-fund buddies are driving BMWs.)
There is some good news. Recent studies have found some evidence of a link between socially responsible corporate policies and superior stock returns, at least over the past decade. Alex Edmans, of the University of Pennsylvania, found that from 1998 to 2005, the stocks of employee-friendly companies (as determined by Fortune’s annual “Best Companies to Work For” list) earned twice the rate of return of the market overall. Other studies have suggested that companies with poor eco-efficiency records do less well than their more environmentally conscientious peers, and that the stocks of companies with strong corporate governance did better than average in the 1990s.
Not surprisingly, SRI advocates seize on such research as evidence that you can do well by doing good. But relationships that seem causal and permanent in one market era often vanish in the next, taking many “superior investment strategies” down with them. Today’s markets are also annoyingly efficient. The more studies that demonstrate that socially responsible stocks do better than regular stocks, the more investors will rush to buy them (and not just for “the greater good”). The resulting torrent of money flowing into the stocks will drive up their prices, and the higher prices will pave the way for subpar future returns.
In discussing how investor expectations could shape the market, Statman suggests that “doing well while doing good” is possible if enough “investors consistently underestimate the benefits of being socially responsible or overestimate its costs [italics mine].” One can always hope, in other words, to get the best of both worlds—responsible practices and superior returns. But finance theory suggests that this hope will stay just what it is now: wishful thinking.
The best news about SRI, and the key to its improving not only mainstream corporate behavior but also investment returns, is that it encourages investors to think like owners instead of renters or gamblers. If you invest the time to analyze a company’s business practices—or, better yet, to change them—chances are you will be more committed to the company’s stock than if you were just looking for a quick score. Why does this matter? Because perhaps the most return-reducing habit for most investors is frequent trading. (This, by the way, is true whether you are a professional port-folio manager running $10 billion or a CNBC-watching dentist running $10,000. Trading is hazardous to your wealth.) Mutual-fund investors, especially, tend to buy at peaks and sell at troughs, thus generating returns that fall far short of what they would have earned if they had just bought and held. Investors who do less trading usually make fewer timing mistakes and rack up lower transaction costs than average traders. Staying put, for whatever reason, is usually rewarded.
Most investors’ obsession with short-term results has another regrettable, and oft-lamented, effect: It encourages company managers to focus on short-term performance at the expense of the long term. In the short term, socially responsible labor and environmental policies can be expensive, so executives who care about this year’s bonus (and who doesn’t?) would be crazy if they bothered to implement them. It is easy to blame companies for this shortsightedness. But the problem often originates with investors, for many of whom a one-to-two-year time horizon is synonymous with eternity.
The flaws and challenges that have confined SRI to a niche strategy in the past reveal the key to expanding its influence going forward. To be meaningful, any analysis of a company’s practices must be painstaking and deep, and screening decisions must be made on objective criteria that others can assess for themselves. Investments must be made for the long term—several years at a minimum and preferably decades—because any incremental value created by sustainable policies (rather than by publication on a Calpers focus list) will likely take years to be realized. Investors should be active partners in a company’s development, sponsoring or supporting referenda or participating in discussions with management—or they should draft behind shareholders who are. And as in all intelligent investing, price must be taken into account. Even if a company’s practices are downright saintly, and even if the saintly practices may help the company deliver superior earnings—far from proven—you won’t benefit if the value of such practices was already reflected in the stock’s price when you bought it. (A Porsche is only a great deal when it is priced like a Volkswagen. Otherwise it’s just a great car—and priced like one.) Lastly, because companies and stocks that satisfy these criteria will likely be few and far between, you will have to live with the risks as well as the potential rewards of limiting your portfolio to a handful of stocks, instead of holding a diversified basket of hundreds.
One firm that embraces an enlightened SRI methodology is Generation Investment Management, founded by former Goldman Sachs partner David Blood, former Vice President Al Gore, and others. The firm’s portfolio is highly concentrated—30 to 50 companies—and the partners seek to make “sustainable” long-term investments, meaning investments in companies that pay careful attention to both human and environmental resources without sacrificing returns. Whether they can achieve this remains to be seen. As with the larger Dow Jones sustainability index, the firm’s focus is on environmental and ethical sustainability rather than on social responsibility, and thus it avoids some of the subjective hazards of negative screening—some.
Ever the evangelist, Gore has begun preaching the virtues of sustainable investing. He is fond of noting that our Keynesian accounting systems assume that the world’s resources, including human capital, are infinite. “We are operating the Earth like it is a business in liquidation,” he says. Gore argues that as the world’s citizens begin to see the light, markets will begin to disproportionately reward companies that behave responsibly. “Your employees, your colleagues, your board, your investors, your customers,” he said in an interview with The McKinsey Quarterly, “are all soon going to place a much higher value—and the markets will soon place a much higher value—on an assessment of how much you are a part of the solution to these issues.”
One implication of this argument—invest sustainably, and you’ll make a killing—is just dreaming. Even if the markets do soon “place a much higher value” on responsible companies, this won’t provide superior returns over the long term; rather, it will provide a pleasant short-term bump. Once stock prices have adjusted, the opportunity will evaporate. Investment decisions, moreover, will still be only one factor in changing corporate behavior. Regulatory practices and consumer buying choices will always play the most direct role in persuading companies to behave responsibly.
All this said, socially responsible investing certainly deserves to go mainstream. Capital-allocation decisions can help shape behavior. Even with different investors emphasizing different priorities, there is usually some common ground. And we need to stop insisting that SRI should be both socially and financially superior to traditional alternatives. It is unlikely to be both, and understanding the trade-offs it requires will have to become a part of how we lead our lives. Organic milk costs more than regular milk—and continues to fly off the shelves. Hybrid cars cost more than regular cars, and we continue to rave about them. For a variety of reasons—some well-founded, some not—we feel good about the trade-off. Specifically, we feel that we are doing the right thing.
A lifetime of investing in SRI funds might cost you a lot more than organic milk and hybrid cars. But as SRI investors become both cannier and more numerous, the sacrifice involved need not amount to the 5 percent you might have lost by boycotting Philip Morris. Perhaps, even if SRI returns are no higher than can be achieved through traditional investing—or even a bit less—the practice can be its own reward.