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Investing for a Cause: Navigating Socially Responsible Investing

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Headshot of Josh Harlan, Director of Investments ResearchBy Josh Harlan

 

 

One of the fastest-growing areas in investment management, in terms of assets and headlines, is impact investing, also referred to as environmental, social, and governance (ESG) and socially responsible investing (SRI). This approach to investing offers investors more control over what their investment dollars are funding. Many investors that consider ESG and SRI:

  • Want to know what companies they’re supporting.
  • Hold certain issues close to their hearts (like climate change, gun control, or tobacco) and prefer (rightly so) that their money not be invested in companies profiting in these areas.
  • Prefer to put more of their money towards investments in companies that they view as doing good for the world (for example, investing in clean water or education).

This type of investing could be thought of as screening out bad companies, on the one hand, and rewarding good companies, on the other hand. The range of policy and social issues that ESG and SRI investing covers is vast, and the space has evolved in recent years. Investors with a desire to invest in an impactful way may understandably feel uncertain about how to proceed.

Evaluating the ESG and SRI investment space requires asking many of the same questions of regular investments, including:

  • What are fund expenses?
  • What is fund turnover and tax efficiency?
  • How is the fund diversified?
  • Who is managing the fund?

Additional questions around socially responsible investing and environmental, social and governance investing include:

  • What specific ESG and SRI issues does the fund target?
  • How does the fund manage the investment process beyond ESG and SRI considerations?

While investing to support a cause is noble, investors shouldn’t lose sight of the fact that they’re investing their dollars with a longer-term objective, such as funding a child’s education, a down payment for a house, retirement, or charity. It’s therefore important to ensure that they’re not sacrificing expected return when pursuing impact investing.

Things to Consider with Socially Responsible Investing and ESG

Areas requiring additional scrutiny when it comes to impact investing may include:

Fees: Investors used to face higher expense ratios for impact investment funds. Thankfully, fees today have come down across the board and investors shouldn’t expect to pay much, if any, higher fees for an impact fund over a broader index fund.

Trading costs: Investors may encounter higher trading costs due to more frequent turnover in impact funds.

Capital gain distributions: Capital gains resulting from realized gains within a fund are another consideration.

Diversification: It is generally accepted financial wisdom that diversification (i.e., holding many different stocks or assets) makes sense because it reduces the likelihood that a single or small number of holdings will have a disproportionate impact on an overall portfolio. The challenge with socially responsible investing and other impact funds is that they feel like a natural area to want to concentrate: impact investors may want to own fewer stocks in higher percentages because those stocks most strongly match an ESG or SRI goal. Balancing these competing interests is something thoughtful investors must work to address.

Tracking error: There’s a large number of ESG and SRI investment options available to match the numerous worthy causes that investors may support, from women’s inclusion to animal rights and from faith-based values to environmental concerns. Although such investing may rest on the idea that a social or political value is of higher concern than economic reward, the financial science underpinning impact investing has evolved significantly. Investors today can anticipate, in a well-constructed solution, around the same expected return—but higher tracking error—compared to standard indexes.

Tracking error means movement around an index; for example, if an index returns 8% per year and a fund has 1.5% tracking error, a range of returns between 6.5-9.5% per year would be expected. The amount of tracking error largely depends on how many ESG and SRI screens are used in conjunction. This takes us back to one of the most central questions of investing: that of risk (volatility) and reward (return).

Putting Thought into Impact Investing

Having a thoughtful conversation and being able to narrow down the list of potential impact investing solutions is one of the responsibilities of a modern financial advisor. The start of a new year is a good time to review overall financial goals and determine if socially responsible investing or environmental, social, and governance investing fits your financial plan.

Do you know anyone who could benefit from these insights? Please pass along this article.

About the author: Josh Harlan is Director of Investments Research at Delphi Private Advisors. The firm offers institutional wealth management in a boutique, personalized service model for high-net-worth individuals and family foundations. Josh can be reached via email at Josh@delphiprivate.com.

 

Disclaimers: Past performance may not be indicative of future results. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of investment management fees, or the impact of taxes, all of which would have the effect of decreasing historical performance results. Indices are unmanaged and cannot be invested in directly. It should not be assumed that your account holdings correspond directly to any comparative indices.

 

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