Ethical Funds: Good Idea, Bad Business
The concept of ethical or socially responsible funds stormed the market well over 10 years ago and by all accounts hasn’t been a profitable venture. We reviewed balanced funds with a 10 year history from The Forum for Sustainable and Responsible Investment and the results were startling:
| Description of Metric | 10 Year Rate of Return |
| Balanced Social Funds (BSF) | 2.67% |
| S&P 500 | 6.16% |
| Dow Jones Industrial Average | 18.99% |
| NASDAQ | 28.47% |
If we dig deeper and consider the returns on a risk adjusted basis, the selected BSF have had dismal returns. It is clear that basic risk and rewards do not match up (especially when we consider fact that the standard deviation is 11.08). That being said Socially Responsible Investing (SRI) now encompasses $3.07 trillion of a $25.2 trillion US market. While 12% is a large segment of the market, attitudes across the world are changing and one has to wonder why this market isn’t bigger? After considering the historical performance of BSF it is apparent that we invest only because we feel compelled to. There is no financial gain from investing in BSF and after we consider inflation one would actually end up with negative returns.
How do we change things and make SRI a core part of our investment strategy? There are two main reasons as to why socially conscious investing hasn’t historically been profitable:
• There was a significant investment trend that focused on bio-diesel and a key ingredient was ethanol. The entire process was not economical without government subsidies. Hence its long-term prospects were limited. Subsidies are political mechanisms to create artificial industries, and once there is a change in government, they are at risk of disappearing. In the US many long-term infrastructure investments were made into bio-diesel plants. As soon as the subsidy disappeared, these investments were written off. In fact the subsidy had negative consequences as it drove up corn prices and put pressure on our food supply.
• In traditional investment funds there are clear objectives and goals. As a result all individuals involved in the fund are experts in that particular field and therefore pick better than average investments. The same is not true for most SRI’s as they are generalist in nature. We should however note that this is a fairly new investment sector and therefore subject matter experts are few and far between. That being said the industry should hone in their investment strategies.
We all want to invest in SRI’s but there is a market void in terms of profitable products. The future is clear; we need to invest in companies that are both profitable and socially conscious. A start would be to develop a new set of performance criteria that leverage on traditional investment metrics. Presently we view SRI’s as an investment that is in its own asset class with its own set of rules. For the future of society and our pockets, this attitude has to change. We should be investing in SRI’s because they are profitable as opposed to investing in spite of their profitability.
Written by: Sam Perera, Financial Savant
Is it really fair to compare balanced social funds with the S&P 500? Balanced funds include bonds and money markets while the S&P 500 is purely equity. Benchmark equity funds for SRI such as the FTSE KLD 400 have actually outperformed the S&P 500.
Environmental, social and corporate governance analysis, which is part of developing an SRI fund, is better able to assess risk within a value chain and efficient use of subsidized resources such as water and energy. It is also better at assessing some intangible assets.
I agree completely that we need to change the way we measure company performance but I think even today there is value in SRI.
Hi Matthew, thanks again for the response. I appreciate the feedback and it is apparent that you have a finance background. It is especially interesting as I wasn’t aware of this index and it is indeed a more comprehensive evaluation of equity based SRI returns. Initially I did some research on FTSE KLD 400, but my understanding is that this has been renamed to the MSCI KLD 400 Social Index. Hopefully we are talking about the same thing. This is preliminary opinion as I need to read up on the index in greater detail, but it appears that this index focuses on large US cap companies and compares their SRI attributes in relation to each other, excluding certain industries such as alcohol and nuclear power. The balanced fund returns focused on pure play environmentally conscious companies. That may explain why the MSCI KLD 400 closely follows the SP 500. Also, I wanted to separate socially responsible only investments from the general investment universe.
I agree that comparing a balanced fund with the S&P 500 isn’t ideal. My rationale for doing so was an attempt to harmonize the volatilities (as noted in the blog posting there is still considerable difference) of the investments.
Perhaps another way of approaching the issue is to explore the relative returns of individual firms within a specific sector and ranking them relative to their social responsibility aspect?
I take issue with your very limited analysis concerning SRI returns. The writer has failed to review the many dozens of academic and institutional studies on this subject.
Just like ‘conventional’ investing, SRI provides returns all-over the map. However, serious, unbiased studies do show that in general, returns on SRI portfolios are as good, and sometimes better, than with most regular portfolios. See Ethical Investing Research/Studies
Best wishes, Ron Robins
PS I’ve been following SRI for about forty years and the link above is to a page on my website. My website focuses on global news, research and services related to SRI.
Hi Sam,
Thanks for your response. I’d say that I know enough about finance to get me into trouble but not always enough to get myself out. My main concern was that the indices being compared were not necessarily comparable.
Even though social indices that invest in large cap companies are invested in many of the companies presently on the S&P 500, investing in those companies through a social index has the advantage of voting in proxy with those with the same values and in some cases passing shareholder resolutions.
Additional volatility in SRI is usually attributed to some funds excluding industries. I read in a book titled “Investing for Change” that one strategy to mitigate the volatility is to screen companies rather than industries.
Another one of your concerns with SRI was the lack of clear objectives in goals. “Investing for Change” also does a nice job of illustrating how SRI can be set up to represent an investor’s goals be it to avoid industries or maximize return.
All the best.