The Conscientious Investor

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.

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.

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.