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More and more investors want to own companies that share their values. Socially responsible investing offers investors the opportunity to make a positive social impact through their allocations while aligning their values with investment decisions.
Socially responsible investing (SRI), also known as ethical investing, sustainable investing, or green investing, refers to an investment process that integrates analysis of a company’s social responsibility with traditional financial measures in pursuit of better returns.
In the past socially responsible investing was often associated with “negative screening”, or avoiding businesses that are involved in alcohol, tobacco, gambling, pornography, abortion, weapons, heavy polluters, and/or companies with human rights concerns. Today SRI goes beyond avoiding businesses and has evolved to integrate environmental, social, and governance (ESG) criteria into financial analysis and decision making.
Traditional financial analysis is an important starting place in evaluating potential investments. ESG is an added layer of investment analysis that evaluates companies on environment, social, and governance factors. By screening companies on the basis of ESG criteria, managers can derive additional insight into the quality of management, potential hidden risks, and the ability of the company to thrive.
Environmental screens look at a company’s energy use, resource management, and pollution record, in concert with their commitments to sustainability and green business practices. Better environmental performance can lead to lower energy costs, reduced regulatory and lawsuit risk, and positive brand recognition.
Social screens evaluate companies on the strength of their employee relations, product integrity, and human rights policies. Companies with higher quality social practices enjoy productivity increases, enhanced brand loyalty, and a reduction in lawsuit and reputation risk.
Governance screens look at the culture of a company. Does the company have accurate and transparent accounting practices? How does the company make decisions regarding executive compensation, salaries, and benefits? Has the company faced legal or ethical issues in the past? Companies with excellent governance ratings can reduce brand risk, avoid negative financial surprises, and are more responsive to shareholder interests.
A 2012 study by Deutsche Bank Group Climate Change Advisors (https://www.dbadvisors.com/globalresearch/climate_change_4822.jsp) found that incorporating environmental, social and governance (ESG) data in investment analysis is “correlated with superior risk-adjusted returns at a securities level.”
“Empirical research has repeatedly confirmed that, when properly managed, risk-adjusted, and controlled for investment style, socially screened portfolios perform comparably to their unscreened peers.” (Social Investment Forum, 2005 Report on Socially Responsible Investing Trends in the United States.)
As the studies above illustrate, applying social and environmental standards does not have to mean sacrificing performance. SRI has an increasing presence within the financial community largely due to the competitive returns that ESG-screened portfolios have generated. The connection is clear. Companies that do not follow responsible business and governance practices will tend to have greater earnings risk due to regulation violations, lawsuits, boycotts, and strikes. Good ESG performance can help protect companies from reputational and regulatory risks, enhance employee productivity, create favorable brand recognition, and significantly reduce energy costs. All of these can potentially enhance earnings and lead to competitive sustainable returns. In other words, ESG screening can bolster performance by both exposing hidden risks as well as identifying companies with strong workplace practices and high quality management.
As a shareholder, investors can have significant influence over the management of the companies they invest in. Through mutual funds, individual investors can pool their voices into one strong voice that has the opportunity to engage companies through direct dialogue, proxy voting, and the filing of shareholder resolutions. Shareholder advocacy can be a powerful tool to promote meaningful economic, social, and environmental change. Investors can literally change the world through their investments.