Responsible investment is an approach or strategy that takes into account governance, social, and environmental factors. Responsible investors acknowledge the fact that assets and businesses underperform when ignoring ethical, corporate governance, or social issues.
Environmental, Social, and Governance Factors
Responsible investment is about opting to invest in businesses that drive change, such as addressing public health issues and growing inequality, mitigating climate change, or improving labor standards. Examples of environmental issues that affect investment decisions are deforestation, pollution, waste, resource depletion, and climate change. Some of the social issues that impact the decision-making process are working conditions, child labor, modern slavery, and human rights. Corporate governance factors that can play a role in the selection of investments are donations and political lobbying, board structure and diversity, executive pay, and corruption and bribery.
ESG integration is basically the inclusion of governance, social, and environmental factors in investment analysis. Issues such as the human resource policies, R&D, and product strategy of a company are analyzed, based on what issues the asset manager or institutional investor prioritizes. The extent to which the analysis is reliable and thoroughgoing depends on the values, sources of information, experience, and background of the analyst.
What Is Socially Responsible Investing?
Socially responsible investing refers to a diverse set of approaches that utilize environmental and social criteria when evaluating companies. Social criteria can cover a wide range of issues such as respect to gender and race, promotion and hiring practices, occupational safety and health, community welfare, etc. Environmental criteria can be things like:
- Waste and recycling
- Impact on natural resources
- Raw material sourcing
- Resource and energy efficiency
- GHG emissions
- Environmental management
Typically, investors score and select companies based on a set of chosen criteria. They first compile a list of qualifying companies and then evaluate their financial performance.
Thematic investment is a subtype of socially responsible investing whereby funds select companies that fall under a specific theme, such as climate change, pollution control, low carbon energy, or water distribution. A healthcare fund, for example, would invest in high-tech companies, nursing homes, health insurance providers, hospitals, and pharmaceutical companies.
Green investment falls under thematic investing and covers a variety of approaches that seek to support eco-friendly or green assets. These can include waste management, recycling, pollution control, and energy efficiency technologies, smart grids, low carbon vehicles, etc.
Impact investing is a strategy that seeks to achieve a specific objective while generating financial returns. Such an objective can be supporting companies that hire persons with disabilities, companies promoting access to basic services such as education, healthcare, and housing, or projects providing employment to community members. Basically, the goal is to generate both positive environmental and social impact and financial returns.
Impact investors range from development finance institutions and family and institutional foundations to wealth managers, financial advisors, pension funds, and banks. The impact investment market has attracted a wide variety of institutional and individual players, including:
- Family offices
- Insurance companies
- Private foundations
- Religious institutions
- Diversified financial institutions
- Fund managers
Socially Responsible Mutual Funds
These funds target and invest in companies that meet environmental, religious, moral, and social standards. They choose the securities that make up their investment portfolio based on both financial and ESG criteria such as policies aimed at fostering social inclusion, reducing poverty, or curbing the carbon footprint. Like other funds, they also seek to invest in companies with robust corporate government policies and strong balance sheets. The three main approaches that socially responsible funds utilize are impact investing, ESG integration, and value-based investing.
Typically, they target companies that employ and train disadvantaged minorities, promote responsible forestry, water and clean air conservation, or fight climate change. When looking into different mutual funds, investors typically account for factors such as experience, performance potential, risks, costs, and the extent to which the investment portfolios align with their values. There is a wide selection of socially responsible funds for investors to screen, a few examples being the SDRP S&P 500 Fossil Fuel Reserve, Vanguard FTSE Social Index Fund, and Parnassus Core Equity Investor. Parnassus, for example, excludes companies within the nuclear energy and fossil fuel sectors while the S&P 500 Fossil Fuel Reserve only targets fossil fuel-free companies. Vanguard eschews investments in companies within the gambling, alcohol, and tobacco sectors, civilian firearms manufacturers, and companies within the nuclear power and fossil fuel industries.
Socially Responsible ETFs
Socially responsible ETFs include a range of assets, including sector, international, and domestic equities. ETFs mainly invest in companies based on factors such as environmental and social impact. The iShares GNMA Bond ETF, for example, provides investors with the opportunity to promote affordable housing. The iShares MSCI ACWI Low Carbon Target ETF offers investors the chance to reduce their carbon footprint by investing in companies across a broad range of sectors, including real estate, energy, communication, and industrials, which are less dependent on fossil fuels. There are also ETFs with a focus on gender equity such as the SPDR SSGA Gender Diversity Index ETF, which invests in companies that help promote gender diversity. Another example is the iShares MSCI KLD 400 Social ETF which excludes companies that are involved in adult entertainment, military weapons, gambling, tobacco, and alcohol.
Socially Responsible Investing vs. Responsible Investing
While both terms are used interchangeably, there are some notable differences. Responsible investing refers to a broad range of strategies that consider both environmental and social factors and financial returns. The three main approaches here are impact investing, ESG integration, and socially responsible investing. With SRI, issuers or companies are excluded /negative screening/ or included /positive screening/ as investments based on environmental or social impacts. Positive screening might favor companies engaged in clean technology and alternative energy, environmental sustainability, or social justice. Negative screening, on the other hand, may mean eschewing investments in companies that have unacceptably high carbon footprints or a poor waste management record. Other negative screens may include labor violations, production of defense tools and weapons, gambling, tobacco and alcohol, and lack of diversity on boards. Exclusionary or negative screening is used to exclude companies within industries such as gas and oil and those that are contrary to international conventions and declarations. Common exclusions can also be:
- Gross human rights violations
- Nuclear power
- Companies operating in a particular region or country
- Hospitals or clinics practicing abortions
- Companies operating in violation to international agreements such as the Rio Declaration on Environment and Development or the Universal Declaration of Human Rights.