Since the dawn of time, man has been given the gift of choice. This concept is reflected in the ancient wisdom literature and the words of great philosophers. The wisdom of Deutoronomy 11:26 written around 1400 BC imparts, "Look, today I am giving you the choice between a blessing and a curse!" The classical Greek philosopher Plato pronounced around 400 BC, "Let each one of us leave every other kind of knowledge and seek and follow one thing only, if peradventure he may be able to learn and find some one who will make him able to learn and discern between good and evil, and so to choose always and everywhere the better life as he has the opportunity."
Every facet of life seemingly has this Platonic element of choosing the better life or the righteous path over the alternative. In the investment realm, the element of doing good through investment choices is called socially responsible investing (SRI). SRI is any investment strategy which seeks to consider both a financial return and the promotion of a social good through a combination of financial support and advocacy for social change. As you would expect, religious organizations have generally taken the lead on this topic. Perhaps the earliest modern day organization to formally encourage socially responsible investment policies was the United States Conference of Catholic Bishops. In 1971, the Catholic Bishops openly challenged U.S. corporations on the issue of apartheid in South Africa. In 1986, the USCCB issued its first formal set of guidelines for socially responsible investing. USCCB ethical investment guidelines seek to: 1) do no harm (like the hippocratic oath) by avoiding participation in harmful activities, 2) to use its role as stockholder for social stewardship, and 3) to promote the common good and social justice.
These goals generally comport with today's evolving SRI mindset which broadly seeks to encourage corporate practices on environmental stewardship, consumer protection, human rights, and diversity. For example, some common negative SRI screening criteria include avoiding businesses involved in alcohol, tobacco, fast food, gambling, pornography, weapons, contraception/abortion, fossil fuel production, and military products. Areas of social advocacy recognized by SRI practitioners are often summarized under the alternative heading of ESG - environment, social justice, and corporate governance.
US-SIF - The Forum for Sustainable and Responsible Investing issued a Report on Sustainable and Responsible Investing Trends in the United States that identified $8.72 trillion in total assets under management at the end of 2015 that used one or more sustainable, responsible, or impact investing strategy. This balance represents approximately 22% of the total assets under professional management in the United States as tracked by Cerulli Associates. US-SIF reports that from 2014 to 2016, SRI enjoyed a growth rate of more than 33 percent, increasing from $6.57 trillion in 2014. The chart below summarizes the scope of SRI activities in the United States (click chart for link to larger image).
The vast majority of the foregoing assets are professionally managed for institutional investors. Current assets under management for retail investors represent a much lower market share than the institutionally weighted 22% reported by US-SIF. Within the ETF (exchange traded funds) market which is Servant Financial's investment vehicle of choice, there are 32 funds with social investment mandates with $2.4 billion of assets under management (AUM). This compares to total AUM in ETFs of $3.4 trillion. This suggests that SRI ETFs represent only about 1/10 of 1% of the ETF market. Furthermore, total AUM of the more mature mutual fund industry is $15.7 trillion. While AUM of $22 billion of the top 5 SRI focused mutual funds is more than 7 times larger than SRI ETF AUM at $22 billion, it still only represents around that same 1/10 of 1% of the mutual fund market.
Despite these statistically low rates of market penetration, there may be some pent up demand for SRI investment solutions among retail investors. A recent survey of retail investors' wealth management preferences by FactSet and Scorpio Partnership of over 1,000 high net worth individuals found that SRI was a particularly hot button for both millennials under 35 and Generation X adults between 35 and 54 years of age.
When asked, "To what extent do you agree that your portfolio should be managed and allocated in a socially responsible manner?," sixty-one percent of respondents under age 35 said they expected their wealth managers to screen investments based on ESG factors. Preferences for SRI were also high in the 35-54 age group with fifty-three percent of Generation X respondents in favor of some type of ESG screening. See the chart below (click chart for link to larger image).
When asked, "In the next five years, how do expect your allocations to socially responsible investments to change?," a whopping 90% of millennials said they expect their SRI allocations to increase either a little (45%) to a lot (45%). Generation X individuals similarly expected SRI allocations to increase a little (46%) to a lot (26%). See the chart below (click chart for link to larger image).
The two primary criticisms against SRI have historically been that 1) the screening processes (both negative and positive) required to identify qualified companies are costly to undertake and 2) the selection criteria in and of themselves will penalize investment performance. The perception of this double whammy to net investment returns (after fund investment management fees) appears to be an artifact of history. A decade or so earlier, the typical SRI mutual fund likely sported an expense ratio in excess of the average mutual fund expense ratio of 1.5%. However, the construction of passive SRI indexes together with technological innovations that allow the broad sharing of screening methodologies from one to many have been driving these frictional costs lower for SRI conscious investors.
A number of passive SRI indexes have been developed based on environmental and social criteria or religious-based criteria (Catholic and Islamic Indexes). The oldest SRI Index is the Domini 400 Social Index, which started in 1990. The Calvert Social Index started in 2000, and the FTSE4Good Indexes dates from 2005. Currently index mutual funds and ETFs are available that track the Domini 400 Social Index, the FTSE4Good Select Index, and the MSCI US ESG Broad Market and ESG Select Social Indexes. MSCI has created a series of social indexes which cover the entire US market and discrete segments of the market based upon market capitalization.
US-SIF publishes a list of over 200 SRI mutual funds. Expense ratios for retail investor share classes among these funds range from 0.44% for a blended fixed income and equity product to 2.4% or more for global, emerging market focused or sector specific strategies. SRI can be executed much more cheaply in more transparent and competitive domestic fixed income and large capitalization equity markets (S&P 500 or Russell 3000) than in international markets or global sector funds.
In 2016, TIAA Global Asset Management released Responsible Investing: Delivering Competitive Performance which argued against the misconception that responsible investment (RI) screens penalize investment performance. In the report, TIAA concluded its "analysis of leading RI equity indexes over the long term found no statistical difference in returns compared to broad market benchmarks, suggesting the absence of any systematic performance penalty. Moreover, incorporating environmental, social and governance (ESG) criteria in security selection did not entail additional risk. RI indexes and their broad market counterparts had similar risk profiles, based on Sharpe ratios and standard deviation measures."
The table below summarizes TIAA's findings (click table for link to larger image within research paper). Note: all of the index performance figures in the table are before (or gross of) fund management fees.
Servant Financial's preferred approach to build globally diversified portfolios for clients is to use low cost, tax efficient ETFs as much as possible. The market development of SRI ETFs is still in its infancy. Whereas there are over 200 SRI mutual funds with over $22 billion in AUM, there are only 32 SRI ETFs at about 10% of the size of the SRI mutual fund AUM.
The largest SRI ETF is iShares MSCI KLD 400 Social ETF (symbol DSI) with $748 million in AUM. This ETF has an expense ratio of 0.50%. It was the second SRI ETF offering when it hit the market in November, 2006. Launched in May 1990, the MSCI KLD 400 Social Index is one of the first SRI indexes.
The MSCI KLD 400 Social Index is designed to provide exposure to companies with high MSCI ESG Ratings while excluding companies whose products may have negative social or environmental impacts. It consists of 400 companies selected from the MSCI USA IMI Index, which includes large-, mid- and small-cap US companies. DSI aims to select companies with the highest ESG Ratings in each sector and maintain sector weights similar to those of the parent MSCI USA IMI index. In addition, DSI excludes companies incompatible with a common set of values screens: alcohol, tobacco, gambling, civilian firearms, military weapons, nuclear power, adult entertainment and genetically modified organisms. The following table summarizes some key facts and the top ten holdings of DSI (click chart for link to larger image).
The oldest SRI ETF is iShares MSCI USA ESG Select ETF (KLD) which was issued in January, 2005. KLD is the second largest SRI ETF with $513 million in AUM. This ETF has an expense ratio of 0.50%. The MSCI USA ESG Select Index is designed to maximize exposure to positive environmental, social and governance (ESG) factors while exhibiting risk and return characteristics similar to those of the MSCI USA Index. KLD is comprised of 100 or more large- and mid-cap stocks and is optimized to be sector diversified, targeting companies with high MSCI ESG ratings in each sector. KLD uses far fewer negative screens than the MSCI KLD 400 Social Index as it only excludes tobacco. Relative to the MSCI USA Index, the MSCI USA ESG Select Index tends to over-weight companies with high ESG ratings and under-weight companies with low ratings. The Index is a benchmark for investors who seek an investment opportunity set with a very high ESG score and controlled risk. Constituent selection is based on data from MSCI ESG Research.
The following table summarizes some key facts and the top ten holdings of KLD (click chart for link to larger image). Note only two of the KLD top ten holdings are also included in DSI.
There are only two other ETFs with more than $250 million in AUM worth mentioning. These ETFs have much more narrow social screens but interestingly both have lower expense ratios of 0.20%.
The iShares MSCI ACWI Low Carbon Target ETF (symbol CRBN) seeks to track the investment results of an index composed of large and mid-capitalization developed and emerging market equities with a lower carbon exposure than that of the broad market. CRBN has $314 million of AUM and seeks to support companies less dependent on fossil fuels by overweighting their stocks relative to higher carbon-emitting peers. This ETF's holdings make it look like a quasi-financial, technology, and consumer focused fund as these three sectors represent 51% of the asset allocation.
The SPDR SSGA Gender Diversity Index ETF (symbol SHE) seeks to provide investment results that correspond generally to the total return performance of the SSGA Gender Diversity Index. The SSGA Gender Diversity Index is designed to measure the performance of U.S. large capitalization companies that are "gender diverse," which are defined as companies that exhibit gender diversity in their senior leadership positions. This ETF has $285 million in AUM and was seeded with $250 million by CalSTRS, the large California pension plan. This ETF is much more diversified than CRBN. Further, academic research shows that firms run by women perform slightly better than their counterparts in return on equity. Companies with strong female leadership sported 10.1% returns on equity compared to 7.4% for companies without a critical mass of woman at the top. This explains SSGA's "Better Together" slogan.
Although the market share for SRI among retail investors appears rather low at less than 1% of mutual fund and ETF assets under management, surveys indicate that SRI is a clear aspirational goal among Millennials and Generation X investors. The ETF industry appears to be in the early stages of developing low cost, tax efficient products around passive SRI indices to address these unmet retail investor needs. Both parties are also operating under a certain set of economic criteria while they endeavor to find a better way or more righteous path to achieve their objectives. We believe there is potentially a budding Platonic relationship here and will continue to monitor socially responsible ETF choices on behalf of our clients.