Investopedia 12/15/2014 Eric Petroff

Provided by Investopedia

Let’s say you want to change the world, but you don’t have a lot of faith in protest rallies or politicians. What can a normal person with a full-time job do to make our world a better place?

Socially responsible investing (SRI) just might be the answer. SRI allows you to express political and ethical views through the unlikely format of investing. At this concept’s core are two competing styles. One style is exclusionary: you create a list of companies that you won’t invest in for moral reasons, and exclude them from your portfolio. The second, more proactive style is inclusive. It involves selectively investing in companies that share your core beliefs or purposely investing in companies that violate them so you can become a shareholder and vote to change company policy.

The Two Sides of the SRI Coin

Exclusionary

These practices are probably the most common approach, and simply involve not investing in companies that engage in undesirable social or ethical practices. Common SRI mandates include not investing in alcohol, pornography or tobacco. Other sinful targets include companies that manufacture weapons or those that have poor labor practices such as using child labor in developing countries. The only thing you need to do with this style of investing is compile a list of companies you want to avoid. This can be very time consuming and expensive if you need to purchase relevant data to make your decision.

Inclusionary

Another common approach to SRI is called activist investing or inclusionary selection. This approach involves investing in companies that either:

• Already support a desired social goal, or
• Are violating a social goal.

By investing in companies that meet your desired ethical values, you are supporting their efforts by increasing their stock price. Conversely, by investing in companies engaging in undesirable practices, you establish yourself as a shareholder to which company management must answer. Therefore, through activist investing you can use shareholder rights to vote proxies in line with your goals and attend shareholder meetings to propose appropriate changes.

The Merits of Exclusionary SRI

Unfortunately, there is little evidence that proves exclusionary SRI mandates have created any material changes, nor is there a theoretical basis to expect they will. Exclusionary investing is based on the concept that by refusing to invest in a given company, its stock price suffers as a result. Because executive and shareholder wealth is tied to price appreciation. the logic is that exclusionary SRI mandates will stagnate this appreciation and force companies to change their ways in the hopes of attracting more investors. The reality of the situation, however, is that it just doesn’t work that way.

First off, simply not buying a stock doesn’t necessarily mean its price will fall. If you really want to drive a stock’s price lower, you will need to engage in short sales. Exclusionary investing can’t really accomplish much in terms of pushing prices lower unless a huge portion of all market participants avoid a company. This has yet to be seen. Part of the problem is that non-SRI investors will see the company trading at a discounted value, and they’ll see an investment opportunity. You also run the risk of a private equity fund taking the company over to unlock its value in the private market.

Additionally, even if exclusionary SRI mandates were able affect a stock’s price, it would still be unreasonable to expect this to force change. It’s a bit of a stretch to assume a tobacco or alcohol brewer will simply abandon its core business because its stock price isn’t increasing.

Exclusionary SRI can also become a slippery slope, where you end up excluding an ever-growing number of companies from your portfolio. For example, hotel chains are innocent enough, but most of them sell pornography in their rooms and alcohol in their bars. If you expand SRI investing too far, you could end up excluding an entire segment of the economy.

Military weapons manufacturers are another prime example. Yes, you can refuse to invest in a U.S. defense company, but it is only making weapons because the U.S. government is buying them. The question becomes, is your problem with the manufacturer or the entire U.S. government? Again, depending on how far you want to take your exclusionary policies, you might not even be able to hold Treasury bonds. a staple of almost any investment portfolio.

Overall exclusionary policies really don’t effect change. The benefit is that the investments will be aligned with your personal beliefs, which can let you sleep a little better at night. However, this is where emotion and ethics can supplant traditional investment logic and reasoning, as SRI investing can involve sacrificing investment opportunities in exchange for the satisfaction of doing the right thing.

The Merits of Inclusive SRI

Unlike the exclusionist style, activist SRI mandates have a lot of merit and there is good reason to believe they can be employed to effect social change. Activist investing works by investing in (and supporting) companies that are in line with your social goals.

A good example is green tech companies that are working to provide alternative energy sources, or firms that treat their workers well or refuse to employ child labor. Additionally, by being active as a shareholder, you can directly effect change. Of course you need to have enough shareholders that agree with you for this to work.

The good news about activist SRI is there aren’t really any inherent flaws in this approach. However, it can entail a lot of work to get things accomplished. Again, the free market economy has spoken in this regard and there are publicly traded mutual funds that will serve as activist investors on your behalf. They will vote proxies in line with stated SRI goals and will attend annual meetings to pursue their agendas. Even an individual with a modest sum of money can participate in these activities.

In fact, there have been some successful changes brought on by small investors. Sister Patricia Daly. a nun and executive director of the Tri-State Coalition for Responsible Investing, has taken activism to a new level by taking her small investments and heading up shareholder proposals to create corporate policy changes. For example, she has gone up against Exxon Mobil to get the large oil company to agree to set emission standards.

The Substance of Style

If you are someone who wishes to effect social change through your investments, it can be a daunting task. However, through the free market economy of the United States you can pool your money with other like minded investors through publicly traded mutual funds or even charitable foundations that employ SRI mandates.

It’s important to remember that SRI may not always have a material impact on a company or increase expected investment returns, but you will sleep better at night knowing you’ve satisfied your moral and ethical goals.