Socially Responsible Investing (“SRI”)

Cáritas is a firm believer in being socially responsible throughout the entire investment process, and we offer 14 high-quality, low-fee, sector/country/asset-class Exhange-Traded Funds in the Socially Responsible Investing (“SRI”) space.

Also known as Environmental, Social, and Governance (“ESG”) investing, here’s a simple definition, taken directly from Wikipedia, and keep in mind that the same strategies underlying our Self-Driving Portfolios, The Intelligent Portfolios, or any self-designed Index ETF portfolio can be applied within an SRI structure:

Socially responsible investing (SRI), or social investment, also known as sustainable, socially conscious, “green” or ethical investing, is any investment strategy which seeks to consider both financial return and social good to bring about a social change.

Recently, it has also become known as “sustainable investing” or “responsible investing”. There is also a subset of SRI known as “impact investing“, devoted to the conscious creation of social impact through investment.

In general, socially responsible investors encourage corporate practices that promote environmental stewardship, consumer protection, human rights, and diversity. Some avoid businesses involved in alcohol, tobacco, fast food, gambling, pornography, weapons, contraception/abortifacients/abortion, fossil fuel production, and/or the military.^[1] The areas of concern recognized by the SRI practitioners are sometimes summarized under the heading of ESG issues: environment, social justice, and corporate governance.

“Socially responsible investing” is one of several related concepts and approaches that influence and, in some cases govern, how asset managers invest portfolios.^[2] The term “socially responsible investing” sometimes narrowly refers to practices that seek to avoid harm by screening companies included in an investment portfolio.^[3] However, the term is also used more broadly to include more proactive practices such as impact investing, shareholder advocacy and community investing.^[4] According to investor Amy Domini, shareholder advocacy and community investing are pillars of socially responsible investing, while doing only negative screening is inadequate.^[5]

The Importance of Asset Class Allocation
Most investors, including investment professionals and industry leaders, do not beat the index of the asset class in which they invest, according to two studies by Brinson, Beebower et al entitled “Determinants of Portfolio Performance” (1986) and “Determinants of Portfolio Performance II: An Update” (1991). This conclusion is also backed up in a third study by Ibbotson and Kaplan entitled “Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance?” (2000). Which begs the question, if a U.S. equities growth fund does not consistently equal or beat the Russell 3000 Growth Index, what value has the investment management added to justify their fees? Perhaps simply buying the index would be more beneficial. (To learn more about active management that gives passive returns, check out Beware The Index Hugger.)

Furthermore, the studies show a high correlation between the returns investors achieve and the underlying asset class performance; for example, a U.S. bond fund or portfolio will generally perform much like the Lehman Aggregate Bond Index, increasing and decreasing in tandem. This shows that, as returns can be expected to mimic their asset class, asset class selection is far more important than both market timing and individual asset selection. Brinson and Beebower concluded that market timing and individual asset selection accounted for only 6% of the variation in returns, with strategy or asset class making up the balance.

Figure 1: A breakdown of factors that account for variation in portfolio returns

Broad Diversification Across Multiple Asset Classes

Many investors do not truly understand effective diversification, often believing they are fully diversified after spreading their investment across large caps, mid or small caps, energy, financial, healthcare or technology stocks, or even investing in emerging markets. In reality, however, they have merely invested in multiple sectors of the equities asset class and are prone to rise and fall with that market.

If we were to look at the Morningstar style indexes or their sector indexes, we would see that despite slightly varying returns, they generally track together. However, when one compares the indexes as a group or individually to the commodities indexes, we do not tend to see this simultaneous directional movement. Therefore, only when positions are held across multiple uncorrelated asset classes is a portfolio genuinely diversified and better able to handle market volatility as the high-performing asset classes can balance out the under performing classes.

Hidden Correlation

An effectively diversified investor remains alert and watchful, because correlation between classes can change over time. International markets have long been the staple for diversification; however, there has been a marked increase in correlation between the global equity markets. This is most easily seen among the European markets after the formation of the European Union. In addition, emerging markets are also becoming more closely correlated with U.S. and U.K. markets. Perhaps even more troubling is the increase in what was originally unseen correlation between the fixed income and equities markets, traditionally the mainstay of asset class diversification.

It is possible that the increasing relationship between investment banking and structured financing may be the cause for this, but on a broader level, the growth of the hedge fund industry could also be a direct cause of the increased correlation between fixed income and equities as well as other smaller asset classes. For example, when a large, global multi-strategy hedge fund incurs losses in one asset class, margin calls may force it to sell assets across the board, universally affecting all the other classes in which it had invested. (For related reading, check out Hedge Fund Failures Illuminate Leverage Pitfalls and Are Structured Retail Products Too Good To Be True?)

Class Realignment
Ideal asset allocation is not static. As the various markets develop, their varying performance leads to an asset class imbalance, so monitoring and realignment is imperative. Investors may find it easier to divest underperforming assets, moving the investment to asset classes generating better returns, but they should keep an eye out for the risks of overweighting in any one asset class, which can often be compounded by the effects of style drift. (To learn more about drift, see Don’t Panic If Your Mutual Fund Is Drifting.)

An extended bull market can lead to overweighting in an asset class that may be due for a correction. Investors should realign their asset allocation at both ends of the performance scale.

Socially Responsible Investing (“SRI”)

Funding your philanthropies™