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Socially Responsible Investing: Noble Not Noteworthy

By: Investor Solutions

By: Investor Solutions

The BP oil spill in the Gulf of Mexico has environmentalists and nature lovers in an uproar and with good reason. The company’s irresponsibility for not having an effective emergency plan in place is going to have long lasting environmental effects on our precious ecosystem. No doubt shareholders and investors are equally disappointed in a company they considered profitable and with potential for future growth and appreciation. But will this event sour investors into investing with companies that are more “socially responsible”?

Socially Responsible Investing (SRI) is an investment approach that considers corporate responsibility and society’s concerns over a number of issues. As of 2007, there were 260 socially screened mutual fund products accounting for approximately $201.8 billion. Socially responsible mutual funds typically invest in companies that are concerned with and take measures towards protecting the environment, dealing with social issues, improving governance and producing “better” or “greener” products. Environmental concerns include clean technology and pollution. Social concerns relate to human rights, labor relations and diversity. Governance, on the other hand, deals with board issues and executive pay. Most encompassing may very well be the products category which includes investing in companies that do not sell or manufacture alcohol, tobacco or weapons, promote gambling or do animal testing.

While the concept of investing in companies whose values align with one’s own is a noble one, financially speaking, it is also an inferior one. For starters, when creating a diversified portfolio you want to include small and large companies, value and growth companies, domestic and international companies as well as alternative asset classes such as real estate and commodities. Unfortunately, though, socially responsible mutual funds are limited in the asset classes that are available typically excluding small value stocks of both domestic and international companies well as international large cap companies and alternative asset classes. If you were to create a portfolio based strictly on socially responsible funds, you would be creating a suboptimal portfolio. You may be further limited by the screens used as you may be interested in a large cap fund that avoids companies that do animal testing but you are in favor of companies that produce weapons as you feel it is a person’s right to bear arms and so forth.

Another downfall of socially responsible funds is their high expense ratios. Although there are actively managed mutual funds with equally high expense ratios, you would be foolish to invest in those when there are superior and more affordable index funds available. A globally diversified portfolio of 50% global equities and 50% fixed income invested in passively managed index funds would have a weighted expense ratio of approximately 0.32% (32 basis points). A less optimal, socially responsible portfolio would have a weighted expense ratio closer to 1.06%. (Less optimal because not every asset class is represented with socially responsible funds). This is a considerable difference in expenses if you consider the effects of compounding over a 30 or 40 year investment horizon.

Even more detrimental than higher expense ratios would be the lower return a socially responsible portfolio has experienced over the last 10 years compared to a globally diversified one invested passively. A passively invested portfolio of 50% global equity/50% fixed income has returned 5.6% with a standard deviation of 8.82% from June 1999 through May 2010. Compare these figures to a socially responsible portfolio returning 3.43% with a standard deviation of 9.13% over the same time period. Using simple time value of money calculations, let’s see an example of how these two portfolios play out. Let’s assume a 25 year old socially conscious professional who, in 30 years, wants to set up her own animal rescue. She is going to scrape by on the minimum in order to save $20,000 a year for her cause. If she were to invest in an SRI portfolio her ending value would be approximately $1 million. On the other hand, if she had invested in a globally diversified, passive portfolio, her contributions would have grown to a figure closer to $1.5 million. A $500,000 difference! So, aside from the noble cause, a socially responsible portfolio is inferior because it has a higher expense ratio, a lower return and more risk.

The funds used for our example are provided in the chart below.

Nearly all of us see injustices in the world that we would like to correct. From human hunger to racial prejudice to animal abuse, we all have a cause that we would like to or do contribute our time and treasure to. And this is a noble undertaking. However, it is important to consider how we can get the “most bang for our buck”. What can we do to make the greatest impact on helping our cause? It would seem that a half a million dollars more to gift during life or at death to our cause would have a far greater impact than shunning companies that have not yet caught up with what is “right” or “responsible”. After all, someone else is going to keep smoking and drinking and gambling which means those companies are not going to go away. So stand up for what you believe in and feel good knowing that you may end up helping even more than you ever thought you could.