What Is Responsible Investing?

Last Updated: 9/2/2021
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If you are conscious about social and environmental responsibility in your daily life, your investment choices are likely no different. But do you have to give up returns to support companies that align with your values?

Whether you're concerned about climate change, diversity, equal compensation or other issues, investing in companies that support causes you believe in can provide valuable returns for your future. Many responsible investors believe that aligning their values and ethics with their investments is part of true financial literacy.

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Simply put, socially responsible investing, also known as responsible investing (RI), refers to an ethically driven and aligned investment strategy for positive personal and social returns. “Sustainable” investing or impact investing are other descriptors that have national interest and credibility. But what exactly do these terms mean?

Responsible Investing Terms to Know

  • ESG Investing: Considers the environmental, social and governance criteria.
  • Ethical Investing: Considers ethical and moral values and religious beliefs.
  • Impact Investing: Considers benefits and effects of a company’s business.
  • Negative Screening: Rejecting an investment because its products or business is harmful to individuals, groups, or the environment.
  • Positive Screening: Investing in companies that make positive contributions to society.
  • Responsible Investing: Considers the social implications of a company’s products and means of doing business.
  • Socially Responsible Investing: Same as responsible investing.
  • Sustainable Investing: Considers companies that combat climate change and protect the environment.
  • Triple Bottom Line: Focuses on social and environmental results as well as profits.

Avoidance Investing Evolves

The RI concept has been around for many years in one form or another. People have long believed in establishing a socially responsible investment strategy as part of their budget and financial plan. Previously, being responsible often largely meant not investing in certain types of business, or regions of the world, broadly viewed as unacceptable. You simply excluded those types of investments from your portfolio.

The classic geographic example of avoidance was South Africa before the abolition of apartheid. The refusal of much of the world to put money into the country helped force its leaders to rethink their racial policies.

For individual investors, the same exclusionary thinking led to not buying any of the so-called “sin” stocks — tobacco companies, alcohol producers and weapons makers were the leading contenders for businesses to be avoided. For other RI investors, defense contractors, fossil fuel producers and chemical companies were similarly unwanted.

The makers of guns, booze and cigarettes remain off limits for most RI-focused investors, as do most owners of oil, coal and natural gas reserves that are still in the ground because by definition, they can’t attain a low-carbon footprint.

But for many other types of businesses, RI investment managers have become much more sophisticated in their approach. The goal now isn’t simply avoiding companies, but ferreting out those companies that score well against what have become standardized environmental, social and governance (ESG) benchmarks.

ESG company evaluated

How Companies Are Evaluated

Driving the shift from avoiding “bad” companies to investing in “good” ones has been an “explosion in data” that a number of data companies mine to determine how well companies score against a variety of ESG benchmarks, explains Jordan Farris, managing director and head of ETFs at Nuveen. He says Nuveen has been incorporating ESG values into its product development process for 20 years.

There are several firms that evaluate how companies are managing risks associated with the ESG benchmarks. The financial analytics company MSCI is one such data provider. The mutual fund analytic firm Morningstar is another.

“They aggregate data from a variety of different sources. From that they are able to identify companies that are leaders or laggards” when compared to various ESG criteria, Farris says. MSCI is his preferred vendor.

In a September 2019 report, MSCI said that it scours “thousands” of data points across “37 ESG Key Issues, focusing on the intersection between a company’s core business and the industry issues that can create significant risks and opportunities for the company.”

Companies are rated on an AAA to CCC scale relative to peers. Individual scores against specific ESG criteria are also available.

ESG Screens to Consider

The ESG factors facing companies are broad and evolving. In the environmental arena, MSCI’s ratings focus on factors that impact areas of concern such as climate change, natural resource management, pollution and waste and environmental opportunities. Drilling down further, the analysis might look at such specific factors as the extent to which a company’s products can be recycled. Social issues can include human capital factors like worker health and safety, labor-management relations, or product liability, to name a few. Governance factors can include executive pay, board diversity, tax transparency and the stability of the management team and other aspects of the way in which companies are run.

“The data has allowed us to build portfolios across all sectors” that can adhere to the beliefs of RI adherents while also producing solid positive returns, Farris explains. “We can compare IT companies against IT companies, or health care companies against health care companies and select those that have been identified as industry leaders within an ESG framework.”

ESG Screens to Consider

Are Investment Returns Good?

But what about performance? While adhering to a “responsible” or “sustainable” investment philosophy is great in theory, if the returns lag behind more traditional approaches, is the concept itself sustainable?

“There is a misconception that you may have to give up performance to invest in RI. That’s a myth. Many RI funds have shown outperformance.” Jordan Farris

According to a study published by Nuveen, RI indexes perform similarly to broad market measures such as the S&P 500 and the Russell 3000 in terms of returns and volatility.

Plus, there’s plenty of investor interest.

“In general, the two groups that lead are millennials and women, but of all clients, more than 50% are interested in learning more about ESG products,” Farris says.

The company surveys investors annually about their attitudes toward RI investing. In its 2018 edition, they found that 81% of individual investors want their investments to make a positive impact on environmental sustainability, 80% “believe investments should try to make a positive impact on society,” and 68% of investors say it’s important to discuss their values with financial advisors.

Advisors, in turn, are learning ESG-focused investments go beyond the old avoidance approach because of that growing interest by their clients. According to the 2018 biennial report from the trade group Forum for Sustainable and Responsible Investment (USSIF.org), “Investors now consider environmental, social and governance (ESG) factors across $12 trillion of professionally managed assets, a 38% increase since 2016.”

As of the end of October 2019, there were 178 mutual funds or ETFs available to individual and institutional investors employing ESG principles offered just by companies that belong to USSIF. Those funds span a wide range of asset classes and sectors, from small cap to large, domestic stocks to emerging markets, as well as bonds and other fixed-income investments. Minimum initial investments for many of the funds run as low $250 for funds purchased in retirement accounts like an IRA, easily bringing them within reach of most individual investors.

“I encourage investors, advisors and clients to work with managers that have experience in this area. You have a lot of firms that have been jumping into the space in the last few years.” Jordan Farris

Do Your Homework

More and more asset management firms are entering the space and not all are USSIF members, which means there are a vast number of choices to consider. As with any investment, it’s critical to do your homework before investing, just as you should before buying any stock, bond or fund. Seek out the ratings from Morningstar or other firms for guidance, and pay attention to costs and historic returns. Consider how the fund fits in with your overall strategy, and if you work with a financial advisor, make sure they share your interest in RI. In short, be responsible about your responsible investing.

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