Sep 23 / Ruairi O'Donnellan

What is Socially Responsible Investing?

Socially responsible investing (SRI) has come to the fore in recent years and is now one of the most widely discussed areas of finance.

In this article (with content taken from Intuition Now’s ESG Investing course) SRI is explained along with the ESG factors it incorporates and the resulting strategies. 

What Is SRI? 

Traditionally, investors have been concerned with one thing: financial returns.

Investors buy assets in the hope that those assets will generate income or increase in value.

In short, investors are interested in making money.

Related article: How is ESG Investing Impacting Executive Pay?

But in recent decades, many investors have begun to move beyond purely financial considerations.

More and more, when making investment decisions, they are considering environmental, social, and governance factors.

This approach is known as socially responsible investing or SRI. It is also sometimes called ethical investing, responsible investing, ESG investing, sustainable investing, or green investing. 
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The history of SRI

SRI traces its roots back to the investment principles of religious groups. In the mid 18th century, the Religious Society of Friends, also known as the Quakers, prohibited its members from participating in businesses linked to the slave trade. 

SRI today 

Today, SRI has expanded to encompass a wide range of issues, including the environment, human rights, employment practices, and community investment.

SRI strategies have multiplied and invested assets with an SRI mandate have increased. 

SRI indices 

In response to the growing demand for SRI options, many SRI and ESG indices have been created. These indices rank and measure companies based on their ESG performance.

They have enabled ESG and SRI investment performance benchmarking and the development of passive SRI investing products.

One example is the S&P ESG index family which offers a suite of country-specific and regional indices featuring companies that perform best on ESG criteria.

The series takes S&P’s existing indices as a starting point and then excludes certain companies based on ESG criteria. 

SRI performance 

Investors who are considering pursuing SRI sometimes worry about their investment performance.

They may be concerned that incorporating nonfinancial ESG factors will mean their investments underperform more traditional portfolios.

Nevertheless, analysis of hundreds of studies shows that SRI delivers investment performance that is either better than or in line with overall market performance and the performance of traditional investment strategies.

Therefore, most researchers agree that investors do not sacrifice performance by pursuing SRI strategies and may in fact enhance it. 

What are ESG factors? 

SRI strategies involve incorporating ESG factors into the investment process.

Environmental (E) factors relate to the natural environment and a company’s impact on it. For example, climate change.

Social (S) factors relate to a company’s relationship with people, including employees, customers, consumers, suppliers, and the broader community.

Finally, governance (G) factors relate to the quality of a company’s management and oversight.

Firms may have good, ethical management, a strong compliance culture, and a shareholder-friendly stock structure.

Alternatively, firms may have unethical management, may face major legal risks, and may be involved in damaging financial scandals.

Understanding, measuring, and monitoring firms’ performance on these factors is core to SRI. 

SRI strategies 

SRI strategies incorporate ESG factors in their analysis of investment opportunities.

Some do so simply to identify hidden risks.

Others use ESG factors to actively screen for firms that are having a positive impact on the world.

To better understand different SRI strategies, it is helpful to make a distinction between investing based on value and investing based on values.

Investing based on value means focusing on the economic or financial value of assets.

Conventional or traditional investing, which focuses on maximizing financial returns, is a type of value-driven investing.

Investing based on values, in contrast, means seeking investments that align with closely held moral and ethical convictions.

Financial considerations are important, but they are not the only or, in some cases, even the primary considerations when it comes to investment decisions.

At the extreme, philanthropy focuses exclusively on values and gives no consideration to financial factors.

We can use the distinction between value-driven and values-driven investing to plot a spectrum of SRI strategies, ranging from those closest to a conventional, value-driven approach to those that emphasize values to the exclusion of financial reward, such as philanthropy.

ESG integration involves simply integrating ESG factors into a broader analysis of financial metrics. It is the SRI approach closest to traditional investing.

Active ownership emphasizes the role of shareholders in encouraging companies to pay more attention to ESG issues. Investors not only consider ESG factors when analyzing a company, but also actively lobby to improve the company’s ESG performance.

Active ownership is therefore more values-driven than ESG integration.

Exclusionary or negative screening and norms-based screening both involve the active elimination of investment options that do not meet a set of ethical criteria.

Best-in-class selection or positive screening involves actively selecting investments that perform especially well on selected ESG criteria.
These screening strategies are examples of the active application of values to the investment decision-making process.

Thematic investment involves investing based on important sustainability themes, such as sustainable agriculture, or clean energy.
Many investment funds focus on thematic investing, which is an actively values-driven strategy.

Finally, impact investment involves making targeted investments intended to help solve environmental or social problems.
Unlike philanthropists, impact investors still seek to earn some financial return on their investments.

However, like philanthropists, they primarily seek to make a positive impact on the world.

This is the most active application of values to investment.
There are many different types of SRI strategy, including:

  • ESG integration
  • Active ownership
  • Negative screening
  • Norms-based screening
  • Positive screening
  • Thematic investing
  • Impact investing 
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