• Investing & Markets

Socially Responsible Investing (SRI) FAQ

December 11, 2018 | Brendan Erne, CFA

This post originally appeared in the Summer 2018 issue of Confident Money, a Personal Capital-sponsored magazine committed to the idea of building confidence and creating the best you at every step of your financial journey. Subscriptions to Confident Money are free.

Why Socially Responsible Investing Matters

As Director of Portfolio Implementation at Personal Capital, Brendan Erne plays a critical role in constructing and managing investment portfolios, as well as building our broader research team. He has also been instrumental in implementing our Socially Responsible Personal Strategy, Personal Capital’s holistic approach to socially responsible investing. Following is an FAQ on all things Socially Responsible Investing and why it is important to Personal Capital clients.

Define Socially Responsible Investing

“Socially responsible” is still a very broad and subjective concept. What one investor deems socially responsible is often completely different from another. Up until recently, it has mostly fallen on each investor to decide what companies, industries or sectors they should exclude from their portfolio – with the goal of aligning their investments with their personal beliefs.

So, if someone didn’t want exposure to tobacco or gun producers, they’d simply exclude them from being purchased in their portfolio. This form of “exclusionary” investing is referred to in the industry as “S.R.I.,” and is the most common form of socially responsible investing being used today.

And while excluding specific categories can be effective, a newer and much more robust form of socially responsible investing is gaining momentum. This methodology is referred to as ESG (Environmental, Social and Governance). It is through these high-level categories that a company’s “social responsibility” is assessed. The “E” covers areas such as carbon emissions and renewable energy projects, the “S” includes policies like employee diversity and safe work conditions, while the “G” encompasses issues like board independence and executive compensation.

While there is no global standard on how to evaluate these metrics, a handful of third-party firms have established thorough research and ranking methodologies. By using these ratings, investors can go much further in their application of socially responsible investing. Instead of simply excluding companies they don’t want to own, they can actively seek out companies doing a better job managing environmental, social and governance issues.

Interested in learning more? Contact a financial advisor.

Why Did Personal Capital Decide to Offer a Socially Responsible Strategy?

This is really the combination of a few different factors, the first being the growing demand from our clients and prospects. Over the last few years, we’ve received an increasing number of requests for some sort of socially responsible offering. We wanted to be able to meet this need.

The second, and perhaps the most important reason, is it just feels right. It’s a natural adaptation to the world we live in. Whether it’s increasing awareness of the environment, disparities in the workplace or other socially conscious issues, there is a growing sense of urgency to do better by the planet and by each other. It seems only fitting we’d want to apply this mindset to investing.

The last reason is we saw an opportunity to produce something truly unique. There just aren’t a lot of socially responsible offerings in the market right now, and most of the ones available suffer from material shortcomings. There was a gap that simply wasn’t being addressed through traditional channels.

How Do You Build These Types Of Portfolios? What Makes Them Different From Your Core Strategies?

The biggest difference between this strategy and our core strategies is the U.S. equity component of the portfolio. Here, we partnered with independent research firm Sustainalytics for their ESG scores and ratings, and built a “best in class” portfolio of individual stocks. This means, on average, companies selected have an overall ESG ranking in the 90th percentile relative to their domestic peer groups. This is far higher than most other ESG funds and ETFs available in the market.

We also removed the energy sector due to its heavy concentration in fossil fuels and filtered out companies with material exposure to adult entertainment, gambling, tobacco, controversial weapons, weapons-related military contracting and small arms.

The rest of the portfolio is built with a diversified mix of more traditional ETFs. This is primarily due to the fact that the industry is so new, and there just aren’t a lot of “ESG-optimized” ETFs with attractive pricing or sufficient liquidity. We do, however, continually monitor what’s available, and fully expect to add some of these funds once they gain a bit more traction.

Overall, the best part of our Socially Responsible Personal Strategy is it retains almost all of the same benefits as our core strategies. We still apply our Smart Weighting methodology, which more evenly weights the factors of size, style and sector. It maintains exposure to all six major liquid asset classes. It’s customizable and data-driven, based on individual financial goals and retirement objectives. And we still take a disciplined approach to rebalancing and tax management.

What Should Investors Expect In Terms of Return Compared to Core Portfolios?

Performance is probably the most common concern for someone considering a socially responsible investment portfolio. And there have actually been numerous studies going back in time attempting to quantify the impact. At this point it is still inconclusive whether socially responsible investing can generate any outperformance, but most studies indicate it can at least match performance of the broader market.

Moreover, a recent study from MSCI (Foundations of ESG Investing, Part 1: How ESG Affects Equity Valuation, Risk and Performance) produced some interesting results around companies with higher ESG rankings. It found that higher ranked companies tended to be more profitable and paid higher dividends, showed lower incidents of large stock drawdowns, and exhibited less earnings volatility and less systemic volatility.

We also conducted an internal back test to determine the impact of removing the energy sector. Over the period tested (1990 to 2017), it actually produced a slightly higher return coupled with a slightly higher standard deviation. So, at the end of the day, I’d say we don’t expect any material performance deviations from our core portfolios over full market cycles. We just might see a tad more volatility given the more concentrated investment universe after removing energy.

How is your socially responsible strategy different from others in the marketplace?

This is where I think we truly shine. As I said earlier, we take a best in class approach to finding socially responsible companies. On average, they rate above the 90th percentile in their domestic peer groups. As a comparison, one of the most widely used “ESG optimized” ETFs is DSI, a fund from iShares. If you applied the same ranking methodology, the fund’s average ESG percentile would only fall in the mid to high 70s. That’s a pretty big difference.

We also incorporate our Smart Weighting methodology to prevent unwanted sector, size and style skews. Many existing socially responsible offerings can have more than a third of their portfolio in a single sector. DSI, for example, is more than 30 percent technology stocks. That’s a huge bet to have on one sector.

Our use of individual stocks also allows for more precise target weights, as well as more granular opportunities for tax loss harvesting. Moreover, it means the portfolio remains fully customizable. If a client doesn’t like a specific company or industry, they can simply restrict it. You can’t do this with a fund or ETF.

The last point is one I mentioned earlier. Our Socially Responsible Personal Strategy comes with all the same benefits as our core strategies. It’s still dynamic and data-driven, based on each individual’s unique financial situation and goals. It simply does all this while also applying a socially responsible filter to the portfolio.

Learn more about our Socially Responsible Personal Strategy.

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