As participants grow increasingly familiar with investing and corporate impacts on social and environmental issues, the demand for investments that align with their beliefs has grown. Socially responsible investing (SRI) is often referred to as “investing with your conscience.” Given the diversity of personal interests, SRI covers a broad range of mandates from faith-based investing to environmental and community impact investing. The differences between SRI fund options can be considerable and their investment mandates can necessitate additional due diligence to understand their objectives, construction and, ultimately, their performance. It is incumbent on plan sponsors to understand these investments and determine their appropriateness and role in the retirement plan’s investment menu. Here we discuss some of the differences found in SRI investments, benchmarking considerations, Department of Labor guidance, and current trends in social investing.
Socially Responsible Mandates
When we talk about SRI today, we are most usually referring to what are now known as “ESG” funds. ESG is an acronym for the 3 key principles of analysis on which these investment mandates are based: environmental impact, social equity, and corporate governance. ESG investment managers screen companies based on their use of natural resources in the development and manufacturing process, and the environmental sustainability of their products and services through the full product lifecycle. The social equity component covers a lot of ground – literally – as it considers how the company treats the communities it enters, employs, and services. Social analysis incorporates respect for human dignity, focusing on the company’s labor relations, workplace and product safety, and community (local, national, and global) accountability. Governance analysis focuses on corporate management and execution, typically considering factors such as corporate ethics, executive compensation, gender parity, and shareholder relations.
Faith-based mandates are another type of socially responsible investment. These funds invest in accordance with the commonly accepted values of the religion on which they are based. As you might expect, “commonly accepted” values can differ even within the same faith, so it is important to research how the fund’s investment criteria are established and amended. Some funds have set up their own advisory councils whose membership includes both prominent clergy and lay members of the faith, while other funds may rely on investment criteria set forth by an independent religious body.
SRI options also exist in fixed income asset classes. These options run the gamut from traditional bond managers offering an SRI version of their funds to impact investors that actively seek out bonds supporting ESG-related projects.
Other types of SRI mandates fall under “impact investing.” Impact investing goes beyond screening to focus on specific outcomes. Certain SRI bond funds focus on community impact, narrowing their investment focus to fixed income securities that advance a particular social cause, such as low-income housing opportunities; other bond funds may focus exclusively on investment in green bonds – a type of bond that funds specific environmental or climate-related projects. There is an increase in narrower equity mandates such as low-carbon funds and funds that explicitly exclude investment in companies that generate revenue from fossil fuels.
SRI Research, Screening & Criteria
Investment managers achieve their SRI investment objectives in a number of different ways, including exclusionary screening, fundamental analysis, and often some combination of the two. Exclusionary screens are a very common SRI approach; in this process, the investable universe is identified (often based on the constituents of a traditional index) and then pre-screened to eliminate companies that participate in business lines that the manager does not wish to support. The most common SRI exclusions are for companies that supply, manufacture, and/or distribute alcohol, tobacco, and weapons. Impact investors may screen out companies that derive a certain amount of revenue from fossil fuels. Funds with social equity objectives often screen out companies that engage in for-profit activity in countries with a history of human rights violations while faith-based funds typically exclude companies that participate in the pornography industry or are involved in stem-cell research.
Other SRI managers incorporate SRI research into their fundamental security analysis, using in-house or third party research. Proprietary research may be conducted by centralized analyst teams that specialize in SRI or may be fully incorporated into the portfolio’s fundamental stock evaluation. In either instance, the managers usually incorporate a review of the company’s public filings, shareholder meeting transcripts, and news coverage, while other portfolio managers go beyond to include meetings with management teams and site visits. The end result is usually a pass-fail or internal rating. MSCI, a global research and index provider, and Sustainalytics, a company focused on ESG-specific research, are among the most cited providers of third party SRI research.
Impact-oriented bond funds often use “progressive” screening, actively seeking out bond issues that meet their investment mandate (environmental or low-income housing projects, for example), then working back to a fundamental analysis of the issuer and project. These managers often require additional transparency around the project and use of funds, as well as some means to measure outcome.
Understanding the screening process is especially important to SRI investment as it dictates portfolio construction and can often be a significant factor in investment performance. Some portfolio managers use a “best-in-class” approach to build a well-diversified portfolio that includes all of the major sectors and industries within their benchmark. This may mean that some lower-rated companies or companies in less attractive industries (such as oil extraction, transport, or refining) are included in the portfolio. Other portfolio managers, especially those with broader exclusionary screening, may significantly underweight or exclude sectors or industries based on their specific SRI mandate. By example, some Catholic equity funds will have smaller allocations to healthcare companies based on their exclusion of companies that develop, manufacture, or distribute contraceptives and companies that participate in stem-cell research. For ESG funds, it is common to find a portfolio with over-weights to technology and service companies as these industries typically have less environmental impacts. Healthcare’s positive impacts to society are often cited as the case for an overweight to the sector. Bond funds often overweight U.S. government, agency, and municipal bonds, since these sectors easily meet their environmental, social, and governance criteria.
Given their mandate to invest with conscience, traditional benchmarking of SRI funds may not be effective. As mentioned above, the specific investment criteria and screening methodology used may have a significant impact to the fund’s performance relative to broad market indices or asset class, especially for funds that underweight or exclude major sectors or industries. Plan sponsors should carefully document their reasoning for an SRI fund’s inclusion in a plan menu and consider portfolio performance relative to the peer group and broad indices with that in mind.
As the SRI industry has matured, more benchmarking tools have been developed. Global index providers MSCI and FTSE Russell currently offer several ESG-based benchmarks. However, the universe of SRI mandates is broad, so if you choose to benchmark SRI performance relative to one of these indices, it is still important to understand the material differences in methodology between index construction and the SRI portfolio.
Trends in SRI
The earliest SRI funds based their screening on exclusion, most often screening out alcohol, tobacco, and firearms. As the industry has progressed over the last 60+ years, the universe of available investment options has expanded considerably. SRI funds can be more expensive than traditional mutual funds due to the additional resource commitments and generally smaller fund sizes. A number of companies have begun offering passive SRI funds that track specific indices such as FTSE4Good Index and the MSCI KLD Social Index and similar to traditional index funds, often have much lower expense ratios than their actively-managed SRI peers.
We are also seeing narrower asset classes and new impact funds offerings. While impact funds have been around for a while, investor demand – particularly in regard to fossil fuel and carbon impacts – has led to new product offerings. These offerings have also expanded beyond the large cap and balanced allocation asset classes to include intermediate-term core bond funds and international equities.
As investors have grown more familiar with ESG investing, we are seeing more traditional investment managers talk about incorporating many of these principals into their fundamental security analysis. The typical ESG governance criteria relate to a company’s alignment with shareholder interests, corporate ethics, and compensation structures – criteria not incompatible with a traditional fundamental manager’s emphasis on investing in companies with strong management and sustainable business models. These managers also cite the business sustainability and headline risks associated with investment in companies that have poor environmental track records. To date, this mostly appears to be a marketing shift by the investment managers as few have amended their fund prospectuses to reflect any SRI addition to their philosophy, mandate, or process.
The Department of Labor Steps In
The U.S. Department of Labor (DOL) issued guidance on SRI in 2008. (The DOL refers to SRI as “economically targeted investments” – ETIs.) The 2008 interpretative bulletin left many fiduciaries wary of offering SRI investments in ERISA plans; however, in late 2015, the DOL issued new guidance (IB2015-01) clarifying their intent. The DOL guidance now clearly states that while a fiduciary’s duty to identify suitable investments remains foremost, SRI considerations can be taken into account when investments are otherwise equal.
Finding the Right SRI Fund For Your Plan
Plan sponsors searching for SRI options are often spurred by participant demand and the interests of the organization, particularly not-for-profit institutions that may work in areas impacted by religious beliefs, support of healthcare and housing availability, or protection of the environment. Given the broad selection of SRI mandates available to investors, it is important for the plan sponsor to identify their investment objective, determine the appropriateness of the investment(s), and document their consideration(s). While SRI fund benchmarking has become easier as new indices have been developed, there are no perfect fits for actively-managed SRI options. It is incumbent upon plan sponsors to understand how the construction of these funds may differ from their asset class peer group and benchmark index and evaluate performance accordingly.
Narrow SRI mandates and highly concentrated funds can result in investment risks that may not be appropriate to a core retirement plan offering. If this is the case, it may be more appropriate to direct interested participants to a self-directed brokerage option or mutual fund window, if available.
Participant communication is another aspect for plan sponsors to consider when offering an SRI option in their investment menu. While some fund names are relatively straight-forward in putting their mandate front-and-center, other funds are less clear. Unless participants read a fund fact sheet or prospectus, they may not be aware that their plan offers a socially-based investment option.
In summary, SRI funds take many forms from faith-based mandates to impact investing. When considering an SRI option, plan sponsors should carefully consider their investment objective before beginning any fund due diligence process. Plan sponsors that already offer an SRI option in their plan should make sure they understand the fund’s mandate, investment criteria, portfolio construction, and mandate-specific risks and measure the investment on both performance and its match to their objective. Fiduciary duty and SRI investment are not incompatible; as the U.S. Secretary of Labor, Thomas Perez, noted in his announcement of the latest DOL bulletin on SRI, “investing in the best interest of a retirement plan and in the growth of a community can go hand in hand.”
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