Values Added

The Ethical Investing Series Part Two: The Values Added Approach

The Ethical Investing Series Quick Links:

Part One: What Is Responsible Investing?

Part Three: How Can You Implement This For Yourself?

In our previous post, we covered the big picture concepts of ethical investing and what levers are available for investors to “pull” to create a values-aligned portfolio that works uniquely for them. In part two of our series, we’ll focus on how we view ethical investing – and how we approach it with our clients. 

As a bit of a disclaimer, before we dive in, this blog post shouldn’t be used as personalized advice. To give you tailored advice, we’d need to know about your financial situation, goals, and values! That being said, this ethical investing system captures our investing philosophy well, and I hope you find it a useful example as you build your own approach. 

Ready? Let’s go!

Your Two Investing “Buckets”

The way we talk about it at Values Added, every investor has two “buckets” in their investing portfolio – a stability portion of their portfolio and a growth portion. 

Stability

The stability portion is traditionally intended to maintain steady, if slow, growth toward their goals. “Safer” or “low-volatility” investments populate this investing bucket (note the quotation marks here – safe, low-volatility, and stable are all subjective terms in this industry that will mean different things based on your goals, risk tolerance, risk capacity and more). For our clients, the“stability” portion of their portfolio usually consists of things like US government bonds, diversified bond funds, municipal bond funds, money markets, CDs, and community investments. 

Growth

The growth portion of a portfolio is where most investors spend their time and energy. It may feel more exciting than lower-volatility funds that aim for slow and steady growth. This “bucket” usually includes investment in public companies like Costco, Microsoft, or a smaller company most people haven’t heard of. Some investors own these company’s stocks directly and some own them indirectly by owning shares in a mutual fund or exchange-traded fund (ETF). This category also includes international and emerging market investment. 

Making An Impact

At Values Added, we have noticed that it can actually be easier to make an impact through how you allocate the “stability” portion of your portfolio. This is true for several reasons. 

  1. This part of your portfolio is where you (directly or indirectly) lend money. That money allows things that haven’t yet happened to happen. If you choose wisely, you can help good things happen that might not have happened otherwise. 
  2. By contrast, investment in public companies is usually exchanging shares that have existed a long time and doesn’t have the same likelihood of funding new activities. 
  3. Community lending, especially when it has a focus on under-served communities can make progress on reducing racial (and gender) wealth inequality. 

The following are investment vehicles investors might consider when building out their portfolio. 

CDFIs

Community Development Financial Institutions (or CDFIs) are organizations that have the primary goal of creating economic growth in distressed and disadvantaged communities. 

They will often offer financial products and services (ranging from traditional banking to small business loans) to local individuals and families. CDFIs offer these financial opportunities in an affordable and accessible way. Their work allows for underserved communities to grow successfully by providing alternatives to predatory lending. 

CDFIs have become more prevalent in recent years, and there are now 1,000+ CDFIs across the country. Investors can support CDFIs through community development loan funds, or depository CDFIs (like banks or credit unions). Worried that CDFIs are more risky than traditional bonds or other low-risk funds? We asked an industry  colleague, Mark Pinsky of CDFI Friendly America, and he had this to say:

“CDFIs manage risk differently than conventional lenders, who are algorithmic. CDFIs are relationships 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, as you noted. 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.”

Impact Notes

An Impact Note is an investment type where individuals can invest  in a basket of long-term investments in a local community or businesses. It is a bit like a mutual fund but instead of investing in public companies, investment notes invest in communities. Impact notes prioritize social impact, and the funding works to grow socially-conscious companies and encourage them to continue making social and environmental impacts through their work. 

Impact notes offer funding which helps entrepreneurs (especially BIPOC and women entrepreneurs) to build equitable organizations that offer competitive pay, health care, and more – all while helping investors grow their nest egg.

Government Bonds: A Comparison

In our experience, CDFIs and Impact Notes are generally similar to treasury/government bonds in rates and durations. For instance, as of this writing a 5-year Calvert Investment Note is available with a 4% interest rate whereas in recent Treasury auctions a 5-year US Bond with the same maturity is available with a 3.625% interest rate. 

Though the interest rates are similar, the US Bonds are backed by the US government and therefore very secure. CDFIs and other institutions have a higher default risk, meaning the chance that they won’t be paid back. The market for investment notes is not as robust as US Bonds since there are fewer people interested and that means that if an investor wants to sell their bonds, they might lose a bit more of its value. This isn’t a problem for people who hold to maturity, meaning that they hold the bond for the whole duration and have their principal returned. For instance, someone who buys a 5-year investment note with a face value of $1,000 pays that much at the beginning, gets interest along the way, and receives their $1,000 back at the end. They can sell the bond to another investor along the way in which case they might receive more or less than the $1000 but if they hold until the end, the promise is that their principal will be repaid. 

For investors who plan to hold some of their bonds for many years, they can often choose a CDFI or Community Investment Note instead of some of those bonds and do more good.

This is why, for many, making the switch to more ethical investments in the “stability” bucket of your portfolio can help them to make the impact they seek without throwing them off the path to reach their goals.

The “Growth” Bucket

Many long-term investors focus on SRI/ESG in their growth bucket. Though there are some appealing options, as with conventional funds, it’s wise to be careful with funds that claim to be green. Sometimes you may find that these funds are associated with higher management fees and/or trading costs–plus, they might not be as green as you think. There are some options who do impactful work, some who have low fees, and even a few that offer both.

There are several ways you can create an ethical strategy in the “growth” bucket of your portfolio – that likely won’t cost you an arm and a leg to set up.

Low-Cost Indexes 

Low-cost index funds are often used by the everyday investor to access a pool of investments for their portfolio, all while keeping costs down. The good news is that there are index funds available in the SRI/ESG space. Some of these funds have much lower expense ratios than the average fund though they all have expenses that are higher than the most affordable non-screened index funds such as main offerings from firms like Vanguard, Fidelity, and Schwab. 

The SRI/ESG index funds have methodologies to screen out companies that don’t meet their criteria (generally ethical, ESG, etc, rather than performance-related). You probably won’t agree with all of their decisions, but if your views about which companies should be screened out are close to the market average, these might be a good fit. A few examples of SRI or ESG indexes with low costs (relative to others available to investors) are the Calvert International Responsible Index Fund or the MSCI World Index Fund, though each situation is different and you should research to find an index or fund that fits your needs!

Shareholder Voting

If you own stocks directly you can exercise your right to seek change through shareholder voting (sometimes also called “proxy voting”). Shareholder voting is just what it sounds like. If you own shares in a large companies as of a certain date, when it has an election you have the chance to vote on the questions on the ballot. The company’s shareholders typically get to vote on corporate governance questions like who will be on the company’s Board of Directors and also issues like whether the company should evaluate its climate risk and develop a plan to mitigate it. For instance, in 2022 18 climate-change-related resolutions won majority votes

As a shareholder, you’re entitled to share what’s important to you. Many people choose to hold big-name brand companies in their portfolios specifically to try and enact change from “the inside.” This may be a more time-consuming process, but for many, it’s absolutely worth it.

If you get very engaged in this area you might even participate in filing a shareholder resolution or supporting other organizations that do. When I worked for AFSCME (a large union), I used to sometimes present shareholder resolutions for the pension fund that our staff participated in. 

If you own shares in a mutual fund or ETF, the management of the fund will vote on those shareholder resolutions. Some funds follow progressive voting guidelines but some don’t. 

Personalized Indexing

Investors who use personalized indexing purchase a sample of all the stocks that make up a particular index. However, instead of making a one-time purchase of a mutual fund share and calling it a day, personalized investing usually involves an investor (or their advisor) regularly rebalancing their portfolio so that as the investments fluctuate and money comes in and goes out, the portfolio is still aligned with the target index. 

This approach is tremendously flexible! It can be customized to each person’s social justice framework. If you don’t want fossil fuel companies generally but want an exception to allow a particular one that is doing more clean energy, you can do that with many providers. If you want to exclude some companies (say arms, fossil fuel, and opioid companies) but want to keep others (say non-opioid pharma) you can often do that too. We find that everyone has a different instinct about what to include and exclude. Because you can choose your own screening and add customizations, this solution is usually more precise and flexible than traditional ESG/SRI options and the provider we use (ethic.com)also less expensive than most of ESG/SRI funds. 

Because proper implementation of personalized indexing is more complex than an ETF – or mutual-fund-based approach, it may be a better fit for people who use an investment advisor who is well-versed in the values, tax, and practical investment management questions that arise.

Tax Efficiency And Ethical Investing

If you do good tax planning, you can give more to causes you care about! We’d be remiss if we didn’t mention the importance of tax efficiency when building out your ethical investing strategy. There are so many ways you can continue to make an impact, all while moving the needle in your own financial life. Here are a few tax concepts that you might find useful:

Another vote for personalized indexing!

Personalized indexing allows people more opportunities to use tax management techniques. There are techniques to use when stocks go down and others to use when they are up. People who use direct indexing hold many individual positions so, though the averages should be the same, there will be way more positions that are winners and losers (since there are more positions overall).   

Tax Loss Harvesting

When a stock goes down it creates a potential tax deduction. But if it goes up again before you take action, the opportunity disappears. Tax Loss Harvesting is when you purposefully obtainthat deduction when it is available by selling the security. Often advisors then invest the money in similar but not identical securities so the investor stays on target and benefits from the future upside. Depending on the specifics, people can save 0.2-1% a year in taxes using this approach and far more if they eventually donate the replacement securities some day or hold it for their whole lives (under current tax law). Personalized indexing tends to create many more opportunities to use this technique.   

Donating Appreciated Stocks

Looking to do good in the world and to minimize your tax bill at the same time? One option may be to strategically evaluate your portfolio and donate stocks that have had significant appreciation to a charitable organization of your preference. This can help to reduce your tax liability, and you’re helping to make a difference for organizations you’re passionate about. In addition to potentially reducing your income tax bill this way, you can also eliminate capital gains taxes (since neither you nor the organization would have to pay them). The more appreciated the investment is, the better this approach works at reducing taxes owed. The most appreciated securities often grow to a disproportionate amount of a person’s portfolio and so donated them can also help reduce concentration and increase diversification. Personalized indexing also tends to present more and better opportunities to use this technique.

The Big Question: What Are Your Goals?

There are so many different ways you can make an impact as an investor – but also just as a human. Sometimes, when you’re looking to create an ethical investing strategy, it can be helpful to ask: 

What are my goals here, really?

For some, doing no harm is their primary goal. For others, they want to follow the “social justice robot” path (we say this jokingly and with love – almost everyone on the Values Added team considers themselves to fall at least somewhat in this category!). In other words, they want to maximize their impact in every way possible, and to find the “perfect” way to create positive change in the world around them. They want to do the most good even if it doesn’t feel the best. 

To do this, they may work to save as much as they can (even if it means investing in “bad” companies), participating in shareholder voting, and then donating or giving away as much money as possible given their lifestyle needs to make an impact. This may work for some!

However, as is the case with most things financial, the majority of investors will need to find a hybrid approach that helps them to invest ethically and in accordance with their values and to meet their personal financial needs and goals. 

It’s also worthwhile to note that your current strategy doesn’t have to be your forever strategy. For example, if you know that in this season of life (parenthood, career, etc.) you don’t have time to participate in shareholder voting actively (or choosing funds that do), finding a way to leverage personalized indexing or low-cost SRI funds exclusively may be your best bet. You can always balance your investing strategy with spending your other resources (think: time and energy!) doing things like volunteering, campaigning, etc. 

In Part 3 of our series, we’ll be covering exactly how to make this work for you – and how to define what “first step” will get you moving on the path to ethical investing. Stay tuned!