By: Seamus Vaughan Lucey
Certain mutual funds attempt to be both ethical and profitable. Early attempts at reconciling the two goals were limited. However, the market for mutual funds now includes a rising number of socially responsible funds for investors who wish to profit without causing harm.
Since beginning in its current form in the early 1980’s, socially responsible investment (SRI) has grown rapidly from a small group of niche funds to representing a significant proportion of all investments made. The United States Social Investment Forum (US SIF) 2014 Trends Report states that the value of US-domiciled assets managed using SRI strategies grew 76 percent from $3.74 trillion at the beginning of 2012 to $6.57 trillion at the beginning of 2014, accounting for more than one in every six dollars under profesofsional management in the US.
Originally, small independent funds offered the majority of SRI investment opportunities. However, as the demand for such funds has increased, larger investment management firms have also created their own funds that use SRI screening methods.
Whilst recent years have seen notable growth in socially responsible exchange traded funds, the major investment vehicle in the SRI world remains the mutual fund, and it is mutual funds that are considered here.
The US SIF report reveals the number of socially responsible mutual funds grew to 415 in 2014, up from 333 in 2012, 250 in 2010 and 173 in 2007. Given this growth, both in the number of funds and the value of the assets they manage, it is worth considering to what extent they fulfill their promise of delivering both profitable and ethical returns.
WHAT MAKES A MUTUAL FUND SOCIALLY RESPONSIBLE?
To begin, it will be useful to outline exactly what a socially responsible mutual fund is and how this is differentiated from a regular fund. Socially responsible mutual funds aim to be profit-making ventures for those who invest their cash through them. But the companies they invest in are not selected purely on their financial performance, but also on the social responsibility of their operations. In theory, this results in individuals buying into funds that provide a profitable return and also meet their desire to have their investments remain ethical.
The criteria for social responsibility can vary widely from one fund to another and between different management practices, from screening investments for the purpose of excluding sin stocks, to actively seeking out investments that have a tangible benefit to individuals, animals, or the environment. Some funds also partake in shareholder advocacy and different forms of community investment. The first socially responsible mutual funds largely concentrated on the avoidance of certain sin stocks, usually including companies involved in alcohol, tobacco, gambling, sex-related industries, and the arms industry. However, as the market has expanded, more funds have emerged that not only seek to avoid what are deemed to be unethical stocks, but also endeavor to invest in companies with positive social or environmental outcomes.
This means that what constitutes an SRI fund is not clearly defined, and consequently there are significant differences between how funds determine their investments. The implications of this will be discussed later.
HOW DO THEY PERFORM FINANCIALLY?
One of the most remarkable things about socially responsible mutual funds is that, even with the limitations on the companies available for them to invest in, they often still perform reasonable well financially, with many funds remaining close to the Standard and Poor’s 500 and some even managing to beat it.
For example, the Parnassus Endeavor fund has beaten the Standard and Poor’s index over the past three years with returns of 23.71% against the S&P’s 17.59%. The Calvert Equity Fund, one of the largest socially responsible mutual funds, has made an average annual return of 8.12% over the last ten years against the index’s 8.13%. Even the Domini fund, which keeps to a stricter screening policy than the majority of large socially responsible mutual funds, only performs marginally worse than the S&P trailing it by half a point per year between 1997 and 2012 with average annual gains of 5.1%.
Indeed, some have argued that the extra criteria used to identify socially responsible companies can be indicative of other factors, not always picked up by purely profit orientated screens, that are likely to lead to the long term profitability of companies. This may be because companies that pass socially responsible screens are disproportionately technology orientated, and are often future focused and innovative. Furthermore, some socially responsible funds take a best in class approach, which further draws their portfolios towards investments in industry leaders.
However, one common drawback for those investing in socially responsible mutual funds is that as a result of the extra work and resources implemented by managers, the fees associated with these funds tend to be higher than regular funds.
ARE THEY GOOD INVESTMENTS?
Even with these higher fees, this loss can be offset if money is invested in a particularly well performing fund, meaning that from a financial position, socially responsible mutual funds can be a good investment, and this is before their ethical value is considered. The possibility that profit can be made while simultaneously creating social and environmental benefit is clearly appealing to many investors, and while the ethical returns of investing responsibly are often difficult to quantify, they are clearly important. The large and growing demand for SRI funds makes this clear.
But do these funds deliver the ethical returns that investors hope for and live up to their name?
HOW ETHICAL ARE THEY?
The problem is socially responsible mutual funds are not always as ethical as one might imagine. There are a huge range of funds included within the field of SRI, with significantly different investment criteria and levels of shareholder engagement. There are also problems in the way that investment managers are able to gain information on the activities of companies potentially being invested in, meaning that even if managers’ criteria for investing are deemed ethically valid they may still find themselves in a position where they invest in unethical companies. Aside from these more practical problems, there is also the question of whether profiting while giving can ever be ethical. Also, in allowing a fund manager to make ethical decisions for them, can an investor in a fund be acting ethically themselves? These problems will be discussed below.
Different funds use different methods for screening potential investments, with the majority of screening falling into two categories: negative screening and positive screening.
Negative screening involves avoiding certain investments on account of the unethical nature of the companies involved. The original socially responsible funds used this method and many funds still use it today. It is the most standardized form of screening with most negatively screened funds avoiding investing in sin stocks.
Funds which use such a screening method usually protect their investors from some of the more obvious unethical investments. However, a negative screen can still leave room for a large number of investments of an ethically questionable nature and the idea that being ethical is simply not investing in companies that are perceived to be actively harmful is a particularly soft form of ethics. Further, some of the criteria for unethical investments are far from being based on a universally accepted idea of what is unethical. For example, it is entirely conceivable that an investor who is committed to using their money ethically does not consider investing in alcohol or gambling to be unethical.
This is a more robust form of screening whereby perceived unethical investments are not only avoided, but investments with a positive ethical value are actively sort out. Parnassus Equity Income, the Domini Social Equity Fund and the Pax World Balanced Fund are some of the largest funds managed in this way.
Though this method of screening is more stringent in terms of its ethical standards, it suffers from the fact there are no objective standards by which to define positive ethical investments. Consequently, those who manage the funds define their ethical direction. Different fund managers have different ideas of what constitutes an ethically positive investment, and any given fund manager’s idea of an ethically positive investment may differ from those whose cash is being invested.
Individuals may well be surprised to find out that included within the portfolios of some positively screened funds are holdings in Nike and BP, companies with significant labor and environmental issues. Some positively screened funds even allow for investments in the arms industry. For example, Calvert Equity, which runs a number of positively screened socially responsible funds, allows for those funds to take holdings in arms manufacturers so long as they make weapons that are not in violation of international law or are ‘not mainly offensive’ – a rather loose definition.
Some positively screened funds allow for investment in companies with ethically mixed practices in cases where it is deemed the beneficial practices carried out by such companies outweigh their negative practices. The Domini Social Equity fund partakes in this form of investing and has its top holding in Apple. Although Apple has made significant efforts to minimize its impact on the environment, it has also been criticized for the working conditions in its overseas factories.
The use of a given company’s products also creates potential ethical problems. For example, an electronics company may make a product that does not go directly to a consumer market but instead various other companies use it in the creation of their products. Some of these companies may well be producing things with no unethical consequence, while others may be using what has been made by the electronics company to design clearly unethical products such as weapons. Companies like this often pass positive screens, despite the questionable ethical value of their products.
Furthermore, a company may itself be committed to creating ethically beneficial outcomes, but be owned by an unethical company, or owned by an umbrella organization that also owns unethical companies. A case in point is The Body Shop, a U.K. cosmetics and toiletry company founded on a commitment to protecting the environment, animals, and indigenous peoples. This company trades on its ethical status; however, in 2006 it was bought by L’Oreal, a company with a questionable ethical record in terms of animal testing. Moreover, 30 percent of L’Oreal’s shares are owned by Nestle, a company that has persistently implemented unethical marketing campaigns in regards to the health benefits of baby formula when compared to breast milk. So although The Body Shop continues to create positive value, some of the profits it creates end up belonging to companies with serious socially responsible failings in direct contradiction to The Body Shop’s principles.
BEST IN CLASS
Some positively screened funds make use of a best-in-class investment model when defining what constitutes a positive investment. The fund invests in the company within a given industry with the best record in terms of social and environmental concerns.
The idea behind such a model is that a market incentive for improving socially responsible outcomes creates a level of competition between firms in this regard. Investors often make companies aware of the criteria they aim for in an investment and in the process encourage the company they are engaging with to work towards those criteria. The creation of an incentive and engagement with company directors is supposed to bring about a change in corporate outcomes within a given sector, whereby meeting socially responsible goals results in greater market value for a given company.
One clear drawback with this approach is that it can lead to investing in a company which is the most ethical of an unethical industry, and in itself cannot be seen as ethical. Such a company would not provide any positive social or environmental outcomes; rather it would provide the least negative outcomes in this industry. Clearly this is misleading when included under a positive screen, in that this approach does not necessitate investment resulting in positive outcomes.
This approach is also predicated on the effectiveness of the investor in bringing about change to corporate behavior. Change is something that depends to an extent on the degree of shareholder engagement that an investor partakes in and also on the circumstances of the company. A well performing large cap company is not likely to be significantly affected by the potential investment of a socially responsible mutual fund, whereas a smaller company in need of equity investment is.
One of the most important ways that SRI funds bring about positive benefits is through engaging with the companies in which they hold shares. Domini Social Investments sees this as integral to defining their organization as a socially responsible investor, with Amy Domini, the founder of the firm, arguing the true definition of a socially responsible investor should be one who engages in some form of shareholder activism or public policy work. Investors let companies know the criterion that informs their decision to invest, try and persuade companies they have equity in to improve certain practices, and work with companies to improve their ethical record. The effects can be extremely beneficial from an ethical standpoint and represent a soft form of pressure used to bring about a change in corporate actions and culture. However, for investors to be deemed socially responsible, there is no requirement to actively engage with the companies they invest in, and many socially responsible investors do not.
Even if we are comfortable with the criteria used by investment funds in defining social responsibility, there is still the matter of how accurately and readily investors are able to acquire the information needed to make an assessment of a company’s socially responsible credentials.
Not all companies make detailed information on their activities available to the public. Given that the details socially responsible investors want to obtain are not always seen as relevant enough to be included in company reporting, these details can be difficult to come by. Although the overall standards of corporate reporting have improved, with socially responsible investing having had a role in bringing this about, standards of company reporting are still not uniform or widespread enough to be suited to the purpose of social investing. Reliability of information remains a significant problem for investors, even with the development of screening processes that make use of questionnaires, interviews and third party sources, as well as more standard corporate disclosures.
Information made available by companies may miss out certain crucial points in regards to the ethical nature of their activities, or be manipulated in order to make the company appear more appealing to socially responsible investors.
Furthermore, in having a need for more extensive forms of corporate reporting than normally required by investors, socially responsible investors often end up with portfolios with a disproportionately high number of holdings in large cap companies. Often big companies listed on major exchanges are the companies likely to have the resources allowing them to commit to the greater level of reporting required by socially responsible funds. Companies that are smaller but with a high level of commitment to socially responsible aims are often disqualified from being considered for investment by socially responsible funds.
DEFINITION AND STANDARDISATION
As a result of the issues surrounding screening methods, investor engagement and the methodological shortcomings associated with socially responsible investing, there is a lack of clear definitions relating to the SRI industry. US SIF, one of the leading authorities on socially responsible investing, uses the terms responsible, socially responsible, sustainable, impact, and ESG (environmental, social and governance) interchangeably in their annual reports, despite the fact that these terms in practice often mean very different investment criteria. Furthermore, US SIF defines SRI as:
“A process of identifying and investing in companies that meet certain baseline standards of criteria of Corporate Social Responsibility.”
This is a very open ended and vague definition tied to the equally undefined practice of Corporate Social Responsibility. Though in recent years attempts have been made to bring greater standardization and clarity to the market, a wide variety of different funds fall within the broad definition of SRI or related terms.
This allows for the possibility of investment companies trading on the notion of being socially responsible while in reality having portfolios made up of investments with questionable or little ethical value. This can be misleading for individuals looking to invest using socially responsible funds, thereby diverting cash that was intended to go into more obviously socially or environmentally beneficial companies or ventures.
THE WITHDRAWAL OF MORAL AGENCY
Aside from the above concerns, one wonders whether mutual funds by their very nature fail to represent an act of ethical value for the individual using them as a means to invest their cash. A theory of ethics based on the idea that ethical decisions must be made by a freely acting moral agent is likely to disallow the idea that investing through a fund can constitute an ethical decision, as it is the fund manager who exercises control over the investments made and it is her decisions that define the fund’s portfolio and its ethical value. An individual putting her money in a fund relinquishes her moral agency and in this respect can be argued not to be acting ethically at all.
One way around this would be for an individual to investigate the nature of the holdings of a fund before investing in it. However, to do so would result in efforts that would negate most of the purpose of investing in a mutual fund with a manager committed to socially responsible investments in the first place.
PROBLEMS OF MOTIVE
Can giving to an ethically worthwhile cause while simultaneously reaping personal gain be considered ethical? If we are to take the stance that ethical value is defined by the intention of the individual acting, then due to the financial incentives of socially responsible investing, it becomes very difficult to differentiate what is done out of the motivation of giving and what is done out of the motivation for personal gain.
Furthermore, some argue for giving to have true value it must be selfless and by profiting whilst also giving, SRI corrupts the cultural value of charity. There may well be some validity in the argument charity loses its cultural clarity and power when incorporated into a financial system that still maintains a profit motive. However, the idea that giving must be selfless is predicated on a notion of limited resources, whereby, to give to another must entail taking away something from oneself as there is only so much to go round, and therefore to give while also receiving is in effect a neutral act. However, such an idea does not necessarily hold true in reality, where it is entirely conceivable that an individual can give to others and gain for herself, with this personal gain coming without the denial of resources to anyone else.
Perhaps it would be more beneficial for an individual considering using a socially responsible mutual fund to give all the money they would invest entirely to ethical causes without endeavoring to receive any of it back. However, this approach fails to see the benefit of the sustainability of investment allowed by SRI funds and also the role some socially responsible investors take in encouraging long term change in the way businesses and finance function.
PROFTIABILITY AS A LIMIT TO ETHICS
Another issue with SRI is that the dual prerogative of profit and ethics can lead to a limited definition of what is deemed ethically valuable. SRI funds must be profitable and this means the only ethical outcomes they can achieve are limited to those delivered by profitable ventures. This means that any ethical outcome that cannot deliver an associated profit falls outside of their potential benefit. In this respect the profit motive has a fundamental effect on what the SRI industry defines as ethical and this is extremely reductive, as a great deal of ethically valuable outcomes clearly fall outside of the range of what is profitable.
Though this paper has considered many of the drawbacks and issues concerning socially responsible mutual funds, it is worth remembering SRI in its current form is still a young, growing, and changing industry. Consequently, these problems may be rectified.
Although not perfect, it is clear with any kind of outcomes-based ethical approach to investing, socially responsible mutual funds are still preferable to regular funds because as a whole they put more money into ethically motivated companies and keep more money out of unethical companies than regular funds.
This is not to mention the hope of what SRI may become. That there is even a market for SRI underlines a pertinent fact; individuals acting within an economy are not always solely motivated by profit and many individuals understand value as defined in ways broader than simple profit. The endeavor to create a model of finance that allows room for clear ethical intention rather than passivity in the face of market forces is something innovative and worthwhile.
Although, the current SRI industry is far from perfect in delivering such a model of finance, it is a step in the right direction. Clearly, the industry must improve if it is to deliver the outcomes that would justify its name, and must become more standardized, clearly defined, and transparent. Within the industry itself, there is a resounding call to implement measures to this effect. Going forward, these improvements are going to be crucial if socially responsible mutual funds are to maintain the trust of those who use them and bring about positive social and environmental change through investing.
Editor: Eric Witmer
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Cartoon: By Scott Adams