Ethical Investing
by Jon Entine
For years, socially responsible investment funds have been hammered by critics for supposedly delivering below market returns. Articles such as "Doing Good but Not So Well"1 suggest that "sub-par" returns have been the norm. So "green" investors and the proliferating number of socially oriented investment advisors were heartened last year when the Parnassus Fund, one of the largest "ethical" funds, reported a five-year stellar return of 21.5 percent. This was a vindication of sorts for a segment of the investment industry that has long believed that ethics and profits need not be mutually exclusive.
"We've been tracking social investments for years," says Peter Kinder, president of Boston-based KLD, which devised the Domini Social Index to measure performance of socially screened stocks. "It hasn't hurt investors to stay out of tobacco stocks or to load up on companies with good environmental or labor records. Just the opposite. Good business practices make good companies, not the other way around."
Today, there are more than 40 mutual funds in the United States and another 12 in Canada that use some form of positive or negative screens. Together, they hold upward of $13 billion dollars; another $3 billion is invested in targeted social investments such as community development banks. Although social investing is a relative drop in the investment bucket?more than $8 trillion dollars is under management in North America?it has a high media profile and various types of social screens are gradually being adopted by many multi-billion dollar pension funds.
Expressions of Social Conscience
On the surface, ethical investing seems a no-brainer for anyone with a modicum of social conscience. "We won't invest in companies that sell tobacco products, or utility and mining firms that use nuclear power," explains David Shuttleworth, vice president of marketing and sales for the Ethical Funds, Canada's largest family of "green" mutual funds. These fund managers invest only in companies that can pass ethical screens that award high marks for good labor relations, generous charitable contributions, and a proactive environmental policy?and filter out firms that are involved in tobacco, alcohol, animal testing, or nuclear power.
A 1995 survey by the Social Investment Forum indicates the relative importance of the issues that have come to dominate current investment screens:
Negative screens
? tobacco 86%
? alcohol 73%
? weapons/military production 64%
Positive screens
? human rights 42%
? environmental issues 38%
? animal rights 24%
? employee relations 22%
"Sin" categories are the predominant social screen. There are compelling financial and ethical reasons to avoid tobacco stocks: the industry has reaped huge financial rewards by externalizing its societal costs, such as the health consequences of smoking, and the industry has consistently engaged in public relations subterfuge and marketing deceptions.
A far more ambiguous issue is the classification of "human rights" as good but defense/weapons companies and alcohol firms as bad. A blind embrace of pacifism is unnerving to anyone with historical perspective. Lest anyone forget, many pacifists and Nazi sympathizers formed an alliance in the 1930s in an attempt to keep the United States out of World War II. As someone who had relatives killed during the Holocaust and was grateful for the U.S. military prowess during the conflict with Iraq, I find a screen on military production in the name of ethics offensive. It may even undermine the proactive goal of curtailing unnecessary defense expenditures. The tougher question is: Which companies are involved in the kind of military research or production that offers a better hope for peace?
The use of alcohol as a screen does not reflect the way almost all people in all cultures live. Unlike tobacco, alcohol used in moderation may have some beneficial side effects, psychological and physical. This "sin" category also screens out some highly progressive companies. Whitbread Plc. (United Kingdom) fails this test because it makes beer, operates pubs, and has fund-raising ties to the Conservative Party. But for decades it has regularly contributed more than 1 percent of pre-tax profits to charity, been involved in community projects with little self promotion, and has earned a reputation for its generous wage and benefit packages.
It's clear that no longer can there be an assumed unanimity about what constitutes "social responsibility." A religious fundamentalist in Iowa does not share many social values with a gay activist in New York. Yet socially responsible funds cater to each of these groups. There are other contradictions: some funds filter out companies that profess support for abortion rights and others screen-in these same companies; many funds screen out defense contractors while others screen-in well-managed defense-oriented weapons suppliers as a matter of principle. And fine distinctions with dubious rationale: Shuttleworth (of Ethical Funds) says he doesn't invest in companies that make packaging for the tobacco industry?unless tobacco-related production represents less than 20 percent of its business. Why 20 percent? "Well, that's just the cut-off point we set," he says.
The contradictions are more than just superficial. For instance, in Canada, where resource companies make up more than 40 percent of the Toronto Stock Exchange, social investors have had to rethink U.S. screening standards that frequently filter out "messy" industries such as timber, paper products, mining, oil production, and the like. According to Michael Jantzi, a Toronto-based researcher who heads a firm that tracks the financial and social performance of Canadian corporations, many of these firms have become leaders in revamping their environmental programs while offering well-paid jobs in a difficult economy.
"I don't want to sound like an apologist," says Jantzi, "but it makes sense to give credit to companies that make major ethical strides." There's also the delicate issue of return on investments. "If you eliminate these sectors, you don't have diversification," says Jantzi. "If you don't diversify, your performance is too volatile, and you won't keep your investors. We screen for 'best-in-sector' rather than trying to measure all companies by the same measuring stick."
Can all of these funds be socially responsible? Yes, if it's recognized that companies touting their social responsibility are really expressing their social values, not ethical business standards. Unfortunately, many of the proliferating group of "ethical" funds don't understand the difference.
Sources of Information
How do social researchers collect their information? Diversification and research are key to investment success. Parnassus, which has a small staff with limited research capabilities, rode some big bets to its recent success. But as the economic waters became choppier over the past year, its fund price has plunged 17 percent. Company research is superficial even at resource-rich Merrill Lynch and other top firms; social research firms have far skimpier resources and overworked, inexperienced staff. They rely on data banks to scan for environmental and other irregularities, but for the most part they depend on company-provided information. That's how ethical investment organizations such as Franklin Research and Development misjudged the social performance of The Body Shop (BSI). "We used public domain articles and questionnaires," says researcher Simon Billenness at Boston's Franklin Research, which gave BSI its highest ratings until dumping its 46,000 shares in 1994. "We learned a hard lesson: never take a company's representations at face value. This is not a science but an art."
Also, social investment firms generally use only what are called "first-level" screens. In other words, progressive funds say they won't invest in tobacco, nuclear power, or defense companies, but they may not screen for banks that may hold huge investments in the very same industries. In fact, banks are a favorite investment of social funds though almost no researchers probe the banks' portfolios. "It's just too complicated, with too many variables," says Jerry Dodson, who heads up Parnassus. It may be too complicated, but without a more complete economic portrait of a company, a recommendation may be little more than a "feel good" soporific to investors looking for painless and lucrative ways to exercise their social values.
"Getting a comprehensive, meaningful screen is next to impossible," says a skeptical William Martello, assistant professor of policy and environment at the University of Calgary. "Concerns like nuclear power and defense spending are not issues of social responsibility but political statements. Funds make subjective distinctions between defensive weapons and offensive weapons, then assign numbers or grades as if they are financial results. It doesn't make sense. These are idiosyncratic ideological filters, not ethical screens."
A Force for Positive Change?
The more challenging question is Do these funds do any good? After getting past hyperbolic claims about helping to end apartheid, there is not much evidence. "The ethical funds movement is just fooling itself," says John Bishop, business professor at Trent University in Ontario. "Investors might 'feel good,' but capital markets are like a swimming pool. Ethical investing, even if you assume that the screens make sense, makes up less than 1 percent of the market. It's like taking a bucket of water out of the shallow end and emptying it in the deep end. It doesn't change much."
Jantzi disagrees. "Companies respond to negative publicity. If we help publicize environmental or ethical inconsistencies, it affects corporate behavior." Jantzi realizes this is not yet a compelling argument. "It's a young movement," he sighs. "Give it time. We're just building our databases."
The corporate responsibility movement might make more headway if it looked harder at its own standards. It's revealing, for instance, what happens when workers, rather than boutique activists, design a portfolio focused on ethical business practices. In 1991, black trade unions in South Africa surveyed members on how to invest their $175-million pension fund. Rather than relying on "ethical" categories popular in North America and the UK, the group came up with its own guidelines for The Community Growth Fund (CGF). Litmus-test social issues such as idealistic mission statements, animal testing, or liquor and beer sales were dispensed with; CGF's most important criteria are product quality, jobs, working conditions, benefits, safety, and equal opportunity.
The unions felt that the creation of well-paying jobs is the greatest need in the South African economy. Economic growth drives job creation, but the unions want their investments to support company expansion, not just the generation of profits. Companies with these priorities and positive industrial relations that recognize worker rights became targets for their investment. Worker-related issues represent more than 75 percent of the screening criteria; political considerations and social spending are considered least important.
This is not to suggest that the social screens used by the South African fund are better or more ethical than most screens currently in vogue. It does suggest that most screens don't represent ethical judgments but popular and sometimes trendy social statements.
Social screens may offer limited potential for modifying corporate behavior. But when combined with aggressive corporate governance, raising environmental reporting standards, and opening companies to more critical scrutiny of their social practices, changing consumer buying habits of products and of stocks can affect a company or industry's reputation and lead to significant reforms.
1Leslie Wayne, The New York Times, December 18, 1993.
A Sampling of Social Investment Screens
The Global Care Unit Trust
Areas of support / Areas of avoidance
People
Community involvement / Alcohol
Education and training / Gambling
Healthcare services / Irresponsible marketing
Health and safety / Armaments
Good employee relations / Oppressive regimes
Policy statements, audits, and openness / Pornography
Socially progressive relationships
Effective corporate governance
Environment
Energy conservation / Greenhouse gases
Mass transit systems / Mining
Multimedia & telecommunications / Nuclear power
Pollution control equipment / Ozone layer depletion
Process control equipment / Pesticides
Recycling services / Road builders
Renewable energy / Tropical hardwood
Water management / Water polluters
Animals
Vegetarian foods / Animal testing
New textiles / Fur
/ Meat and dairy production
South Africa's Community Growth Fund
(In order of importance with the most important criterion listed first)
Job creation policy
Industrial relations
Conditions of employment
Training
Equal opportunity for women
Health and safety
Type of product
Privatisation
Profit retention
Affirmative action
Location of company assets
Environmental management
Disclosure
Worker participation
Political profile
Social spending
In addition, all criteria are assessed for evidence of racial discrimination
Domini Social Equity Fund
Strengths / Concerns
Community
Generous giving / Controversies
Innovative giving / Breach of agreements
Support for housing
Support for education
Diversity
CEO / Controversies
Promotion / Non-representation
Board of directors
Family benefits
Women and minority contracting
Employment of the disabled
Progressive gay and lesbian policies
Employee Relations
Strong union relations / Poor union relations
Cash profit-sharing / Safety controversies
Employee involvement / Workforce reductions
Strong retirement benefits / Pension and benefits concerns
Environment
Beneficial products and services / Hazardous waste
Pollution prevention / Regulatory problems
Recycling / Ozone depleting chemicals
Alternative fuels / Substantial emissions
Communications / Agricultural chemicals
Non-U.S. Operations
General non-U.S. operations / General non-U.S. operations
Community / Burma
/ Mexico
Product
Quality / Product safety
R? innovation / Marketing/contracting
/ controversy
Benefits to economically disadvantaged / Antitrust
Other
Limited compensation / High compensation
Ownership
Exclusionary Screens
Alcohol
Tobacco
Gambling
Military
Substantial weapons contracting involvement
Minor weapons contracting involvement
Major weapons-related supplier
Nuclear power
Derives electricity
Design
Fuel cycle and key parts
The above article appeared in appeared in the September/October 1996 edition of At Work AtWorkNews@aol.com, by Berrett-Koehler Publishers. Jon Entine is a writer and Emmy-winning television news producer who won a National Press Club award for consumer journalism for "Shattered Image: Is the Body Shop Too Good to be True," published in Business Ethics (September 1994). He can be reached via e-mail: runjonrun@earthlink.net.