The goal of investing is how to get the best return while balancing factors such as taxes, inflation, interest rates, world events, and dividends. But these days, investors—particularly the generation just entering the market—are increasingly interested in the power their money has to positively impact society and the environment as well as benefiting them financially.
In fact, values-based investing has quickly transformed from the zeitgeist among younger investors to a vital part of the way companies do business. According to US SIF Foundation’s 2020 trends report, assets under management in the US using ESG (environmental, social, and governance) strategies grew to $17.1 trillion by the beginning of 2020, up from $12 trillion only two years earlier—a 42% increase.
What is socially responsible investing?
Socially responsible investing (SRI) is an approach to investing that prioritizes companies that have a good record in what are known as ESG issues: environmental, social, and governance. Ethics, workplace practices, product safety, human rights, community relations, and the rights of indigenous or marginalized communities are also taken into consideration.
In practice, this includes the following tactics:
- Screen for negatives. SRI investors might rule out investing in so-called sin stocks: alcohol, tobacco, firearms, cannabis, defense, fossil fuels, and gaming stocks.
- Look for positives. Positive investing—also known as impact investing— involves actively seeking out and investing in companies whose values align with the investor’s own. Some socially responsible funds look for companies that have signed on to the Ceres principles, a code of environmental conduct developed by the nonprofit Ceres Group. They might also analyze companies’ CSR, or corporate social responsibility reports, to make sure their actions align with investor values.
SRI vs. ESG: How they’re similar but not the same
The SRI and ESG acronyms are often used interchangeably. Both are oriented toward building more responsible portfolios, but there are key differences between the two:
- Environmental, Social, and Governance (ESG). ESG is a system for measuring the sustainability of a company in three categories: environmental, social, and governance. While ESG investing obviously has the goal of being socially responsible, its bottom line is financial performance. It usually uses positive, or impact investment strategies to add responsible investments.
- Socially Responsible Investing (SRI). Socially responsible investing, ethical investing, and impact investing are more general terms for responsible investing, and essentially the goal is to eliminate investments that don’t adhere to ethical codes. It usually uses a negative screening model to rule out investments.
Performance of socially responsible investing vs. traditional investing
Investors once worried that social responsibility could compromise financial performance, but research now suggests just the opposite. In 2021, the Morgan Stanley Institute for Sustainable Investing found that sustainable funds outperformed their peers during the 2020 pandemic. Analyzing more than 3,000 US mutual funds and ETFs, it found that sustainable equity funds outperformed “non-ESG peer funds” by a median total return of 4.3% in 2020.
Morningstar’s 2021 Sustainable Funds US Landscape Report found the same results, and data for the past five years also showed that returns of 69% of ESG funds ranked in the top half, and 41% in top quartile returns.
History of socially responsible investing and how it drives change
While social responsibility has become more and more crucial to investors in recent years, shareholders have long understood the power their dollars can wield. The roots of socially responsible investing can be traced to the 18th century Quakers in America, who refused to take part in the slave trade or invest in weapons of war, and to early Methodist leader John Wesley, who declared that people shouldn’t make money at the expense of others’ welfare. Specifically, Wesley counseled against that era’s equivalents to today’s sin trade: gambling, usury, and industries that used toxic chemicals.
The Securities and Exchange Act of 1934 allowed an investor or group of investors who own at least 1% of a company’s stock to influence the behavior of the companies—one way in which socially responsible investors affect change from the inside out. The move toward investing for social justice evolved in the 1960s, when people began using their funds for investing in causes that promoted civil rights, equality for women, and labor rights. Impact investing gained traction during the 1980s, which is also when the oldest investment advisor devoted specifically to SRI, Trillium Asset Management, was founded.
One powerful example of investment money promoting global change was demonstrated by many of America’s powerful college endowments, which pulled out of companies that did business with South African companies in the 1980s. This divestment helped hasten the end of Apartheid.
How do socially responsible investors evaluate companies?
The ESG criteria companies and investors use are generally not part of mandatory financial reporting and aren’t standardized. However, companies do disclose their ESG practices in annual reports and separate sustainability reports.
Institutions including the Sustainability Accounting Standards Board, the Global Reporting Initiative, and the Task Force on Climate-Related Financial Disclosures are working to create standards by which companies and investors can measure ESG adherence. Until there is a single measurement, a good way for investors to educate themselves is to read about these organizations’ efforts and compare their investments.
One choice for investing in ESG is to buy into a fund that has a high ESG rating by a reputable source. For instance, Forbes Advisor has rated these funds as the best-performing ESG funds as of January 2022:
- Vanguard FTSE Social Index Fund (VFTAX)
- iShares MSCI USA ESG Select ETF (SUSA)
- Parnassus Core Equity Investor (PRBLX)
- iShares Global Clean Energy ETF (ICLN)
- Shelton Green Alpha Fund (NEXTX)
Forbes Advisor’s methodology for picking these funds included comparing 80 funds that focus on ESG investing, each with at least three years each of performance data. They looked at independent research that scored the companies’ performance in addressing ESG issues, and considered how each fund selects ESG companies and debt.
One concern among investors is “greenwashing,” or labeling a company as socially responsible or ESG that doesn’t merit the moniker. The Biden administration has called for standardization of ESG investments, and non-profit watchdog companies seek to help companies follow through on their initiatives.
Investors can make their own evaluations by looking at one-year financial returns, returns since inception, expense ratios, and methodology for picking or excluding companies. To avoid companies making false ESG claims, investors can look for third-party verification, ESG fund impact reports, and financial advisors with chartered SRI counselor certification.
Types of SRI and ESG investments
Investors have a wide range of SRI and ESG products and asset classes to invest in. Here are the major types:
- Mutual funds and ETFs. US SIF publishes a list of 180 sustainable investment mutual funds and ETFs offered by its institutional member firms. Investors can research the performance of individual ESG securities on the MSCI KLD 400 Social Index, the capitalization-weighted index of 400 US securities companies with high ESG ratings that excludes companies with negative social and environmental impacts.
- Alternative investments. Private equity and venture capital funds, property funds, and REITs represented the biggest alternative investment vehicles for ESG, according to US SIF’s 2020 report. PE and VC ESG funds increased 21% from 2018 to the beginning of 2020 to 681 funds, with $438 billion in assets under management, a 55% increase. In 2020, assets managed by alternative investment vehicles totaled $716 billion, up 22% from the $588 billion held by the same kinds of funds in 2018.
- Community investments. This sector includes credit unions, venture funds, and community development banks, and has grown from 2018 to 2020 by $266 billion, a 44% rise. Socially responsible investors can lend money directly into community organizations through these community development financial institutions (CDFIs), which can be found through the National Community Investment Fund (NCIF) and credit unions through the National Federation of Community Development Credit Unions (now Inclusiv).
- Microfinance. Some investors like to invest money through microloans, which are small loans made directly to small and startup businesses. Well-known microlending organizations include Kiva, which offers microloans to business owners in developing countries, and Kabbage, which loans to entrepreneurs in the US.
The bottom line
For an increasing number of investors, socially responsible investing is an important way to align the way they invest with their ideals and even affect global change. With the rise in ESG and SRI research, and companies’ increasing commitment to disclose their environmental and social programs, it is easier than ever for investors to understand if a company’s philosophies match their own. And while the SRI and ESG terms are still not completely standardized, ethical investors can see them as useful additional criteria for traditional investing, allowing them to invest in companies that work for positive change.