Values Added

The Ethical Investing Series Part One: What Is Responsible Investing

Ethical Investing Series Quick Links:

Part 2: The Values Added Approach

Part 3: How Can You Implement This For Yourself?

When you hear the term “ethical” or “socially responsible” investing, what do you think of? Some people think of investing in solar energy, and others think of excluding companies they don’t support from their portfolios. Some people think about supporting small start-ups trying to make a difference in the world, and some people think about shareholder activists holding companies accountable. Responsible investing can mean different things to different people. We want to build a shared language of the options and help you determine which approach might be the right fit for you.

In this series, we’ll review:

  1. What responsible investing is and why people pursue it.
  2. What options are available for people who want values-aligned investments, including how investors implement responsible investing and what strategies exist to help you achieve this goal.
  3. How to define your personal “why” or your motivation for investing responsibly to clarify  what strategy is the right one for you.
  4. What you can do beyond investing to make an impact.

Today, we’re covering the basics: What is responsible investing, and what options exist to accomplish it?

What Is Responsible Investing?

Investing money in a values-aligned way is not new but “socially responsible” funds, investing methodologies, and financial planning experts specializing in responsible investing have gained tremendous momentum recently. The idea of leveraging wealth to support causes we as investors care about (and not support industries we find problematic or abhorrent) often resonated with investors, and it has for centuries.

In the United states, as far back as the 1700s, we see religious groups boycotting the slave trade, gambling, industries that produced toxic materials, tobacco, and alcohol (just to name a few). The responsible investing movement evolved throughout the 1960s and 1970s, when social activist groups and labor unions began to use Socially Responsible Investing (SRI) to support the civil rights and labor movements and empower companies that were making an impact. In the 1980s, divestment helped build the movement to bring down South Africa’s Apartheid government. 

More recently, the term Environmental, Social and Governance factor-based investing (ESG) has become prominent.This may reflect a change in the issues investors are most concerned about as equity, environmentalism, and workers rights emerge and some concerns about alcohol and some other “sin” areas become less prominent. 

Today,investors increasingly care about alignment between their investments and their values and the broader financial services industry has started to respond. One third of total US assets under “professional management” are invested using “sustainable investing strategies” according to The Forum for Sustainable and Responsible Investment.

Investors today are much more likely to want to know that their wealth is making an impact on the causes they care about, and are less likely than ever to want to profit off of businesses that they feel aren’t acting in alignment with their values. In other words, they want to: 

  1. Do good with their wealth and support causes they care about.
  2. Avoid doing harm by withholding funds from companies that score poorly according to ethical criteria. 
  3. Actively pressure companies to stop doing harm by using their investments to participate in shareholder voting and activism.
  4. Work toward their personal financial goals. 

Of course, in some situations, these goals may conflict or have some tension – further adding to the confusion investors experience. For instance, some people want to avoid owning bad companies but also want to see those companies improve. Those approaches are in tension because by avoiding owning the company they have given up their voting rights, one of the more effective ways to help change the company. Throughout this series, we’ll outline different strategies investors can use to determine what their goals are and what investing responsibly looks like for them. 

Defining Key Terms

Responsible investing goes by many different names – SRI (socially responsible investing) or ESG (environmental, social, governance) are two of the most common that you’ll hear. Of course, to make things more complicated for investors, there are no generally accepted definitions for any of those “types” of responsible investing. So, to ensure you feel empowered in your investing journey, let’s define some of the most commonly used terms as best we can. 

The truth is that SRI and ESG are incredibly similar. Yes, they may have different origins, but they all are rooted in the same core concept – investors want to use their money in an impactful way by buying stock from “good” companies), and avoiding companies that are “bad.” 

The key is to focus on the core elements of each of these concepts, and how they can be used as “levers” you can pull in your strategy. 


Since the terms are so common and people often ask, here’s a quick overview of each, as defined by the Values Added team:

SRI (Socially Responsible Investing): Socially Responsible Investing, or SRI, is generally a catch-all term for investing in a value-aligned way. SRI Investing emerged as a common term earlier, and was meaningfully influenced by Christian denomination’s views on investing, especially Methodists, Catholics, and Quakers–leading to extensive discussion of “sin” companies. SRI focuses on investing in companies that are socially conscious, and environmentally responsible.

ESG (Environmental, Social, Governance): ESG is a style of investing that attempts to limit risk by applying environmental, social, and governance criteria to vet companies and investing in ones with stronger records in those areas. ESG emerged later as a term, perhaps signaling the de-emphasis on religious themes and an increasing focus on equity, the environment, and treatment of workers.

The Three Levers You Can Pull

Within the SRI/ESG/Impact umbrella, you can pull several investment “levers” to create an ethical investing strategy that works for you. 

Screen Well

In general, most SRI/ESG funds (imperfectly) screen out companies who aren’t meeting a specific set of criteria in the following categories – environmental, social, governance (ESG). Here are a few of the specific “red flags” that prompt screening from investors and larger fund managers:

Environmental:

  • Pollution
  • Climate change
  • Preservation
  • Animal welfare
  • Energy consumption/conservation
  • Waste production/how it’s handled

Social: 

  • Human rights
  • Child labor
  • Health and safety of employees and buyers
  • Employee and stakeholder relations
  • Data protection and security
  • Customer satisfaction
  • Community relations

Governance:

  • Management quality
  • Board composition and diversity
  • Audit structure
  • Corruption
  • Executive compensation
  • Lobbying
  • Political contributions

Companies are ranked based on these metrics using public reporting (it’s important to note that reporting in these categories isn’t mandatory for companies). Then, ESG funds use the criteria to filter out businesses that score poorly or violate the ESG criteria and standards. At Values Added, our clients will often use personalized indexing (more on this below) with funds that screen for ESG criteria.

Who is it for? This particular “lever” is for those who don’t want to profit from things they are opposed to, or that go against their values. It is also useful for people who think that companies with better approaches on these issues may outperform expectations.

How do you do it? There are two schools of thought on the best way to “screen well” as an investor. If you’re looking for a simpler option, there are many ETFs available that focus specifically on SRI/ESG screening. If you want a more tailored option, you can look toward personalized indexing. 

What is personalized indexing? While this term may not come up often in your SRI or ESG research, we want to define it here because it’s something we’ll discuss as part of this series. You may have heard of index funds. This type of mutual fund was developed in the 1970s and is now the most common approach to investment. Rather than picking which stocks you think will do well, or even having a mutual fund manager try, you buy shares in a fund that owns nearly all the companies in a specific index (basically a long list of companies). For instance, a “Total US Stock Market” mutual fund invests a portion of the money invested in nearly all publicly traded US companies. Everyone who invests in the mutual fund owns a small percentage of the mutual funds’ holdings.

Since we all have slightly different preferences and mutual funds are the same for everyone, they will usually screen out things you wouldn’t and leave in things you’d prefer to be screened out. Because of advances in technology, many people don’t need to have a mutual fund company in the middle anymore. This is great because it allows you to actually personalize this same strategy based on your preferences and needs. With this approach, you hold many individual positions. You can decide that you want the whole market or to exclude opioid manufacturers, fossil fuel companies, guns and military companies, or other things.

You can be as precise or general as you like. In my experience, nearly everyone has a different perspective about which sectors and sub-sectors they’d like to include/exclude and this approach is one that can be customized in that way. 

When we began researching , personalized indexing (also called direct indexing) it was costly and often out of reach for most investors due to high fees, transactions costs, and minimum-account sizes that excluded most households.. However, in the past few years, some important developments like technological advances, zero-commission trading, and new competitors have made this approach much more affordable and accessible for investors. It’s not the focus today, but I’d be remiss if I didn’t note that this approach may have significant tax advantages, especially for people who donate to tax-deductible organizations. 

Shareholder Advocacy

Also called “active ownership,” shareholder advocacy allows investors to make an impact while investing in companies (even the “bad” ones). In other words, they use ownership in “bad” companies (or companies that don’t pass the ESG criteria) to participate in shareholder voting to create active change from within organizations. These techniques can also be used with “good” companies to help them become better. 

Who is it for? Investors who are ready and willing to dig in and vote as a shareholder and to participate in shareholder advocacy strategies. Many people don’t care to research each vote but do want to know that their mutual fund/ETF has good policies and will vote their shares in a way that moves companies toward being better.

How do you do it? Instead of focusing on filtering out companies that don’t meet the traditional SRI or ESG criteria, those who subscribe to the shareholder advocacy school of thought often invest in all companies (based on their unique financial and lifestyle goals). Then, when a company that violates its values or ESG criteria is in its portfolio, they work to effect change from within an organization through shareholder voting, voicing concerns, and joining with other like-minded shareholders. Some investors do use funds that screen out the worst companies but are active with shareholder campaigns at all companies they hold.

Community Lending and other Off-Wall-Street Strategies

Your third and final “lever” to pull focuses on alternative investing and lending methods. 

Who is it for? This non-wall-street activity can be a complement to the above strategies or even a main strategy. These investments help things happen in the world that might not have otherwise.

How do you do it? For example, instead of using traditional corporate or US government bonds or “low-risk” investments, investors may look to CDFIs (see below). Or, instead of buying stocks from large companies, investors might choose to individually invest in small businesses (perhaps local) or organizations that are doing good and making an impact in the world.

CFDIs (Community Development Financial Institutions): CDFIs came into being in the 1960s-1970s and offer varying forms of “self-help credit.” CDFI.gov says:

“[CDFIs are] offering tailored resources and innovative programs that invest federal dollars alongside private sector capital, the CDFI Fund serves mission-driven financial institutions that take a market-based approach to supporting economically disadvantaged communities.”

Their goals are often to develop communities through alternative lending structures and support low-income individuals and families to obtain financial support for businesses, housing, and other community-building expenses. SRI and ESG funds primarily invest in publicly-traded stocks (Coke, Microsoft, Costco, etc.), but CDFIs are banks, and most investors engage with them by loaning them money which they, in turn, loan in the communities where they are active. CDFI investing may be considered a form of Impact Investing. The rates of return are often as good or better than the normal savings and CD rates from big box banks, if not quite the very highest rates one could find by shopping around. Investors can also provide capital in exchange for modest or no return to increase the ability of the CDFI to lend at low rates.

“CDFIs manage risk differently than conventional lenders, who are algorithmic. CDFIs are relationship lenders who mainly hold assets in portfolio and service their loans closely and personally. Many CDFIs look at credit scores (when applicable) but very few actually include them in underwriting. 

For the most part, CDFIs are cash-flow lenders. In addition, non-regulated CDFIs (I.e., loan funds) use their flexibility to work out non-performing and under-performing loans, rather than letting them default. It’s a huge thing (making a case for less regulation, ironically) that is reflected in the net charge off numbers. That said, for loan funds at least, delinquent loans are consistently higher than any financial institution regulator would allow but steady and predictable across a portfolio, even in extremely bad credit environments. 

Last, of course, loan funds are over-capitalized and under-leveraged, which gives enormous confidence to investors. In addition, well-run loan funds (the only ones I’ll deal with) maintain high loan loss reserves (LLR), higher than past performance would require. There is an ongoing debate between the big CDFI investors (think, Bank of America) and CDFI auditors, who sometimes believe that loan funds are hiding cash in LLR.”  – Mark Pinsky, Founding Partner, CDFI Friendly America

One example of a CDFI that the Values Added team has watched grow over the years is Hope Federal Credit Union. They have truly transformed access to credit for POC communities across the Gulf Coast, all while engaging in advocacy to “mitigate the extent to which factors such as race, gender, birthplace, and wealth limit one’s ability to prosper.” 

How is success measured? 

We define success with responsible investing in one of two ways:

  1. Financial gains or progress toward personal financial goals.
  2. Ability to make an impact or to avoid harming/transforming harm through shareholder voting. 

Of course, “success” will look different for each investor based on their unique goals, values, and motivations. There are many different ways to invest responsibly and to do so without committing to one “greenwashed” fund that doesn’t necessarily make an impact or accomplish your values-driven goals. 

For some investors, this may look like building a personalized indexing strategy that aligns with their personal values and financial goals. For others, this may look like investing a step further by investing in a land trust, banks that lend to affordable housing developments and worker-owned companies, angel investing in start-ups, or pursuing political causes or candidate contributions to make an impact. In Part Two of our series, we’ll dig into the “how” of responsible investing and bust a few common misconceptions and myths surrounding the topic. 

We’ll see you then!

You should always consult a financial, tax, or legal professional familiar about your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Past performance does not guarantee future performance. Future returns may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost.