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12.1 Introduction to Socially Responsible Investing (SRI)

Learning Objectives

  1. Describe what is meant by socially responsible investing (SRI).
  2. Explain what a mutual fund is and what can be of interest to individual investors.
  3. Understand why many investors were reluctant to invest in SRI funds.
  4. Describe how Pax World helped to convince individuals to invest in SRI funds.

Socially responsible investing (SRI)An investment strategy that considers the social value or merits of an investment in addition to its financial considerations.—also known as sustainable investing—refers to investment strategies that seek to not only provide financial return but also be consistent with moral values and have positive societal impact. SRI can be as straightforward as an investor who avoids investing in any industry they find morally questionable—such as a tobacco manufacturer—to as complex as a billion-dollar fund that screens in or out many different types of investment opportunities based on key performance indicators in environmental and social areas.

SRI recognizes that corporate responsibility and societal concerns are valid and important criteria for investment decisions. While SRI refers to a spectrum of investing activities, in general, SRI will be referred to as a broad-based approach that invests in companies that manage themselves in ways related to sustainability, including environmental protection and human rights. However, as mentioned previously, SRI can also be morally based and avoid so-called sin industries, such as those involved in alcohol, tobacco, gambling, animal testing, or weapons.

SRI roots back to biblical times, as Jewish law provided specific guidance on ethical investment. In colonial times, Quaker and Methodist immigrants to the United States brought with them the concept of values-based investing exercised by their refusal to invest in slavery or war. In the 1700s, Methodist reverend John Wesley (1703–91) outlined his basic tenets of social investing—including not to harm your neighbor through your business practices and to avoid industries, such as tanning, because of their potential to harm the health of workers.

Modern SRI can trace its roots to the 1960s and 1970s in the United States as concerns over civil rights, the Vietnam War, gender equality, the environment, and nuclear power all emerged.“History of SRI,” SRI Conference, http://www.sriintherockies.com/about/historyOfSRI.jsp. Pax World Funds was created in 1971 as the first SRI mutual fund by Luther Tyson and Jack Corbett, both of whom worked for the United Methodist Church, for investors who did not want to invest in companies involved in the Vietnam War.

SRI investment grew dramatically in the 1980s as significant societal events—for example, apartheid in South Africa, the nuclear disaster in Chernobyl, and the oil spill in Alaska by the Exxon Valdez—led millions of people and organizations to invest in companies that were more socially and environmentally responsible. Other social phenomenon in the 1990s, such as Nike’s use of sweatshops, increased respect for indigenous populations, and tropical deforestation, further supported investment in SRI. By 1995, SRI had grown to fifty-five mutual funds with $12 billion in assets under management. Most recently, climate change has motivated new waves of SRI investment by both institutional investorsOrganizations that pool large sums of money and invest those sums in securities, real property, and other investment assets. Examples include banks, insurance companies, college endowment funds, retirement or pension funds, and mutual funds. and individual investors.

SRI mutual funds now span a wide range of investments opportunities, including domestic and international securitiesA fungible (interchangeable), tradable financial instrument representing financial value, such as stocks, bonds, or options.. In addition to mutual funds, a growing number of financial products are becoming available that target SRI, including hedge fundsInvestment funds that are flexible, can be illiquid and leveraged, and tend to be marketed to sophisticated high net worth individual investors and institutional investors. and exchange traded funds (ETFs)Investment fund with features similar to a mutual fund, except that it is traded on an investment fund traded on stock exchanges, much like stocks..

The performance of SRI funds has slowly convinced investors that there is not a significant trade-off—and there even may be some positive correlation—between social and financial performance. At the end of 2009, a review of 160 socially responsible mutual funds found that 65 percent of the funds had outperformed their benchmarks—funds with similar investment objectives.Jason M. Ribando and George Bonne, A New Quality Factor: Finding Alpha with Asset4 ESG Data (New York: Thomson Reuters, 2010). Between 1995 and 2010, SRI had grown significantly.

As of 2010, there were 250 mutual funds using SRI criteria in the United States, with assets of $316.1 billion.“Sustainable and Responsible Investing Facts,” USSIF, http://ussif.org/resources/sriguide/srifacts.cfm. These funds increasingly compete with traditional mutual funds and SRI-focused funds, such as Pax World Funds, and increasingly compete with the mutual funds industry giants, such as Fidelity Investments, Vanguard, and T. Rowe Price, who have started SRI funds as part of their family of funds. Investors in the traditional funds are increasingly likely to move at least some of their assets to an SRI investment approach. How fast they do this and how much of their investments they direct to SRI funds and to mutual fund companies that only engage in SRI, such as Pax World, will depend on how important a sustainability- and moral values–based approach to personal financial investing becomes for households in the United States and in other nations and also on SRI fund performance and marketing.

Mutual Fund Industry

At the end of 2010, there were 7,581 mutual fundsInvestment vehicles that are pools of funds that allow retail investors to invest with relatively low amounts. in the United States with combined assets of $11.8 trillion, according to the Investment Company Institute (ICI), a national trade association of investment companies in the United States. This is about 80 percent of the size of total US annual economic activity (gross domestic product) of $15 trillion. Worldwide assets invested in mutual funds totaled $24.7 trillion.

Mutual funds are investment vehicles that are made up of a pool of funds collected from many investors for the purpose of investing in securities, such as stocks and bonds. Anyone who invests in a mutual fund receives shares of the fund. Each share represents an interest in the fund’s total investments, often times called its investment portfolio. Portfolios include equity (ownership) shares in a large number of publically traded companies and bond holdings. Bonds are similar to loans and are issued by companies and public entities, such as cities and states, and purchased by mutual funds and other investors.

The value of mutual fund shares rise and fall depending on the performance of the underlying securities (stocks and bonds) in the portfolio. Similar to a shareholder in a corporation, an investor receives a proportional share of income and interest generated by the portfolio mutual fund units, or shares. Shares can typically be purchased or redeemed (sold) directly from the mutual fund company at the fund’s current net asset value (NAV)The value of a share of a mutual mutual fund that is based on the closing market prices of the underlying securities in the fund’s portfolio. per share.

In 2010, more than fifty-one million US households invested in mutual funds, or about 44 percent of all households. The median number of mutual funds owned by households was four and the median amount that fund-owning households invested in mutual funds was $100,000.

Mutual funds have advantages compared to direct investing in individual securities, including increased diversification, daily liquidity, professional investment management, service and convenience, and ease of comparison. One of the main advantages of mutual funds is that they give diversification to investors with relatively modest amounts to invest. Disadvantages of mutual funds include management fees and less control over timing of recognition of capital gainsA profit that results from investments into a capital asset, such as stocks, bonds, or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor. or capital lossesArises if the proceeds from the sale of a capital asset are less than the purchase price..

In the United States, all mutual funds are registered with the US Securities and Exchange Commission (SEC). The SEC was formed after the stock market crash of 1929 in response to abuses in the widely unregulated financial securities markets. Its mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”“The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation,” US Securities and Exchange Commission, http://www.sec.gov/about/whatwedo.shtml. Under the 1940 Investment Company Act, which governs the mutual fund industry, a mutual fund consists of the shareholders and a board of directors (if organized as a corporation) or board of trustees (if organized as a trust) who are fiduciariesSomeone who has undertaken to act for and on behalf of another in a particular matter in circumstances that give rise to a relationship of trust and confidence. charged with acting in the best interests of the shareholders. A fiduciary duty is the highest standard of care. A fiduciary is expected to be extremely loyal to the persons to whom it owes some responsibility; the fiduciary must not put its personal interests before its duty and must not profit from his position as a fiduciary, unless the principal explicitly consents.

The board of directors or trustees is charged with hiring a professional money manager or investment adviser to manage the assets of mutual fund. The fund manager, also known as the fund sponsor or fund management company, invests the mutual fund’s assets in accordance with the fund’s investment objectives. A fund manager must be a registered investment adviser. The fund manager’s responsibilities include portfolio management, legal compliance, operations, and marketing. Mutual fund managers generate revenue by charging investors fees, usually as a percentage of funds managed. These fees are called management fees. The fees normally vary from .3 percent to 1 percent of funds under management.“Socially Responsible Mutual Fund Charts: Financial Performance,” USSIF, http://ussif.org/resources/mfpc. Multiple mutual funds that are managed by the same fund manager and that have the same brand name are known as a “fund family” or “fund complex.” The two largest mutual fund companies have total assets well above $1 trillion (see Table 12.1 "Five Largest Mutual Fund Companies by Assets under Management, November 30, 2009").

Table 12.1 Five Largest Mutual Fund Companies by Assets under Management, November 30, 2009

Top Five Fund Families Assets under Management (in Billions of Dollars)
Vanguard 1,313.39
Fidelity Investments 1,215.41
American Funds 926.68
JPMorgan 449.41
iShares 360.07

The largest single mutual fund, American Fund’s Income Fund of America, had net assets of just under $69 billion in 2011. The largest SRI mutual funds’ single funds are small in comparison, Parnassus’ Equity Income Fund has $3.7 billion and the Pax World Balanced Fund has $1.8 billion. The traditional mutual fund companies have also started SRI funds, which are included in their total but these funds are a small portion of their family of funds.

Types of Mutual Funds

The types of mutual funds vary according to a fund’s investment objective. A fund’s investment objective will usually seek capital gains (gains from the sale of portfolio securities), income (interest and dividends earned on the portfolio securities), or a combination of both. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectusA document required by federal law to be provided to investors before investing in a mutual fund or other specific types of financial investments. It provides information useful to investors to help them understand the risks associated with the investment..

The following is a list of common categories of mutual funds:

  • Money market. A money market fund seeks the safety of principalThe original amount of a debt or investment on which interest or return on investment is calculated. by investing in high-quality, short-term securities. This type of fund is designed with the aim that an investor’s principal should not decrease in value.
  • Growth. A growth fund invests primarily in the common stock of well-established companies. This type of fund may invest for long-term capital gains.
  • Income. An income fund invests in debt securitiesAn obligation that pays interest regularly.. Hence this type of fund is designed for investors who desire periodic income payments. There are, however, substantial differences and varying degrees of risk among income funds depending on the credit quality of the debt issuer, the maturity of the debt instrument, and the prevailing interest rates.
  • Balanced. A balanced fund, as the name implies, invests for both growth and income. The fund will invest in both equity and debt securities. A balanced fund seeks to provide long-term growth through its equity component as well as income to be generated by the portfolio’s debt securities.

SRI Industry

As of 2011, the Forum for Sustainable and Responsible Investment, SIF (formerly the Social Investment Forum), identified $3.07 trillion in total assets under management using one or more of what SIF defined as the three core SRI strategies—screening, shareholder advocacy, and community investing.“Sustainable and Responsible Investing Facts,” USSIF, http://ussif.org/resources/sriguide/srifacts.cfm. This includes mutual fund investing. Between 2007 and 2010, SRI experienced a 13 percent growth rate from $2.71 trillion in 2007. About one out of every $8 under professional management in the United State—or 12.2 percent of the $25.2 trillion in total assets under management tracked by Thomson Reuters Nelson—was involved in SRI.

Three Core Approaches in SRIThis is taken from “Sustainable and Responsible Investing Facts,” USSIF, http://ussif.org/resources/sriguide/srifacts.cfm.

There are three core approaches in SRI. First, screening is the practice of evaluating investment portfolios or mutual funds based on social, environmental, and good corporate governance criteria. This includes both positive and negative screens. Positive screening, or “buy” indicators, involves including strong corporate social responsibility (CSR) performers, avoiding poor CSR performers, or otherwise incorporating CSR factors into the process of investment analysis and management. Generally, social investors seek to own profitable companies that make positive contributions to society. “Buy” lists may include enterprises with, for example, strong environmental practices, products that are safe and useful, and operations that respect human rights around the world.

Conversely, many social investors avoid investing in companies whose products and business practices are harmful to individuals, communities, or the environment. This is a negative screen, or “don’t buy or sell” indicator. It is a common mistake to assume that SRI “screening” is simply exclusionary, or only involves negative screens. Positive SRI screens are being used more and more frequently to invest in companies that are leaders in adopting clean technologies and exceptional social and governance practices.

Second, shareholder advocacy involves socially responsible investors who take an active role to encourage corporations to improve their social and environmental practices. These efforts include talking (or “dialoguing”) with companies on issues related to environmental, social, and governance (ESG) issues. Shareholder advocacy also frequently involves filing shareholder resolutions on such topics as corporate governance, climate change, political contributions, gender or racial discrimination, pollution, and labor practices. Shareholder resolutions are then presented for a vote to all owners of a corporation.

The process of dialogue and filing shareholder resolutions generates investor pressure on company management; often garners media attention; and educates the public on social, environmental, and labor issues. Such resolutions filed by SRI investors are aimed at improving company policies and practices, encouraging management to exercise good corporate citizenship, and promoting long-term shareholder value and financial performance.

Third, community investing directs capital from investors and lenders to communities that are underserved by traditional financial services institutions, such as banks. Community investing provides access to credit, equity, capital, and basic banking products that these communities would otherwise lack. In the United States and around the world, community investing makes it possible for local organizations to provide financial services to low-income individuals and to supply capital for small businesses and vital community services, such as affordable housing, child care, and health care. Community investing is the fastest growing area of SRI. From 2007 to 2010, community investing grew more than 60 percent, from $25 billion to $41.7 billion in assets.

Among the mutual fund companies that use an SRI-type approach, Pax World is commonly recognized as the third largest (http://ussif.org/resources/mfpc).Because of the broad definition of socially responsible investing (SRI), it is difficult to do a standard accounting of all the funds that engage in SRI and SRI-like investing. Parnassus Investments (http://www.parnassus.com), based in San Francisco, has about $6 billion in assets under management. Calvert, which includes both SRI and more traditional investing, has sustainability-focused funds of approximately $5 billion (http://www.calvert.com/sri.html). All the SRI funds, as with other investment funds, were larger in assets before the financial crisis of 2008–9. Pax World experienced nearly a 40 percent decline in assets under management during the sharp stock market decline.

Smaller SRI funds have been consolidating over time. For example, Sentinel Funds (http://www.sentinelinvestments.com) bought Citizens Funds in 2008. And further consolidation is expected as some of the big, traditional mutual fund firms enter the market and try to buy SRI mutual fund firms or consider launching their own suite of SRI-like products to compete with Pax World Investments and other SRI funds in response to increasing numbers of institutional and private investors asking for funds with social objectives.

Key Takeaways

  • Socially responsible investing (SRI) refers to investment strategies that seek moral values and social impact and provide financial return.
  • Mutual funds are investment vehicles that allow investors to receive professional management, diversification, and liquidity for a relatively small investment.
  • Pax World helped start SRI and the sustainable investing industry by forming the first SRI mutual fund in 1971.
  • In starting the industry, investors had to be convinced that attention to social and environmental concerns had positive influence on company financial performance.
  • There is evidence to suggest a positive link between social and environmental performance and company financial performance.
  • Three core SRI strategies are screening (both positive and negative), shareholder advocacy, and community investing.

Exercises

  1. Discuss the spectrum of investing that is classified as socially responsible investing (SRI). Go to a company’s website and see what actions they take related to sustainability, such as environmental practices or water usage. After reviewing, does that change your view of the company? Are you more or less likely to invest in the company now?
  2. In 2006, Parnassus Investments (http://www.parnassus.com) added an exclusionary screen to exclude investing in businesses involved with Sudan when the international community recognized the Darfur region conflict as genocide. Do you agree or disagree with these criteria for a SRI investment? What might be unintended consequences of a screen like this?