The Road to Socially Responsible Investing: Strategies and Challenges
Key Takeaways
- Every Socially Responsible Investing strategy has its strengths and challenges, but how well it works depends on the investor's goals and values.
- Positive screening is an investor-fueled approach to investing only in proactive companies. Negative screening minimizes reputational risks. These two strategies may restrict investment options and need deep study.
- Norms-based screening is a solid foundation for corporate behaviour evaluation. However, it requires regular monitoring and lacks universal norms against which to check.
- Leading Performer Screening promotes industry-wide positive change and enables sector diversification. But "best-in-class" is also easier said than done.
Socially responsible investing (SRI) has grown in popularity in the last decade as people have access to more information regarding environmental, social, and governance (ESG) factors. If investors are going to align their investment portfolios with ESG principles, it is essential to understand the various approaches to SRI.
What is Socially Responsible Investing?
SRI stands for socially responsible investing, which means that while making an investment, the strategy takes into account not only the financial return but also some societal benefit or change. SRI has roots in religious movements of the 18th century, where investments were made or avoided based on moral consideration. Over the years, SRI has evolved to include a wide range of strategies that are in line with investors’ goals of sustainable and ethical investing. As a result, defining socially responsible investing is difficult because of the differences in people’s values.
Investors engaged in SRI use four screening techniques to identify securities that actively reflect certain standards. Each method is important in its own way since it applies a different strategy to constructing SRI portfolios.
1. Positive Investment Screening
Positive Screening is known as the process of identifying companies or industries that meet specific ethical, social and environmental standards. Shareholders look for firms that are pioneers in environmental protection, social responsibility or corporate governance, which can be especially advantageous to the economy and can result in long-term economic stability and development. Renewable energy projects are a good example of positive screening where investors fund organizations that enhance environmental responsibility. Another example would be selecting companies known for their robust labour rights policies and fair treatment of workers.
While positive screening fosters investment in progressive organizations, which will likely benefit the economy, it limits the list of investment opportunities as not all firms fit the criteria. Moreover, this method involves a lot of research and analysis to identify the qualifying companies, making the whole process more time-consuming and costly to investors.
2. Negative Investment Screening
Conversely, negative screening involves striking any name from your company list or portfolio that does not comply with prescribed ethical standards. This is a typical strategy for those investors who want to avoid certain sectors like tobacco, firearms, or fossil fuel. For instance, the Norwegian Government Pension Fund Global does not invest in companies involved in gross environmental and human rights abuses (NBIM, 2022). This approach assists the fund in preserving its image, contributes to achieving sustainable development goals worldwide, and ensures that its financial activities align with its core values.
Like positive screening, negative screening can also limit the number of investment opportunities available. This restriction may reduce the portfolio's diversification and exclude potentially profitable securities. This can raise the risk level and reduce the investment's total financial profitability. Therefore, while negative screening ensures that investments conform to ethical standards and mitigate reputational risks, it can reduce the potential for greater returns and a diversified portfolio.
3. Norms-Based Screening
Norms-based refers to investments that comply with global standards and norms, such as the UN Global Compact or the OECD Guidelines for Multinational Enterprises. It also gives an immediate test of the morality of corporations against global measurements regarding human rights, labour, environment, and anti-corruption. Those standards are commonly applied by investors engaging in norms-based screening to analyze corporate behaviour and potentially exclude companies that breach these principles. This means an SRI portfolio would exclude a firm that uses child labour or engages in corrupt practices, following norms-based screening guidelines, as it does not comply with global standards and norms. In contrast, negative screening excludes companies or sectors based on specific activities deemed undesirable, such as tobacco, alcohol, or fossil fuels, regardless of their compliance with broader norms.
The advantage of such a screening technique is that it forces companies to harmonize with global standards, promotes business ethics in an environmentally friendly way, and gives investors one way to understand and examine corporate conduct. On the other hand, there is a potential for inconsistency in the interpretation and enforcement of norms since different stakeholders with a vested interest in corporate behaviour, such as investors, regulators, NGOs, consumers, and sometimes even employees, might have varying views on what constitutes adherence to these standards. For example, environmental protection standards might be enforced strictly in some regions but overlooked in others, or human rights expectations may differ between countries. This inconsistency can lead to disputes over whether a company truly adheres to the standards. Moreover, they require full company monitoring and verification, which might be expensive regarding human resources.
4. Leading Performer Screening
Leading performer screening involves selecting top-tier companies within their industries. Rather than omitting an entire sector, this method incentivizes the best performing within each to be identified and for investments made to better everyone overall (RobecoSAM, 2021). For instance, an investor may decide to invest in the least environmentally damaging firms in the oil and gas sector, hence supporting the leading firms in the sector shifting towards sustainability.
A primary advantage of leading performer screening is that it incentivizes other companies in the field to increase their investment and sharpen their practices. For instance, a top performer in ethical fashion could be an apparel company that uses sustainable materials (organic cotton or recycled materials) and produces garments ethically from the raw material to the end product. It can also encourage other companies within the industry to perform better and enhance their sustainability and ethical performance to compete for the industry's leading performers.
Moreover, this strategy permits sectoral diversification while keeping ethical principles. For instance, investors can broaden their portfolio by adding top-class companies from different sectors, including renewable energy, healthcare, and consumer goods. This is meant to filter out those who stand behind the industry leaders committed to ethical practices.
While the process of choosing the best-performing company in a particular sector might be more or less arbitrary, the problem becomes even more complex when constructing an investment portfolio. Suppose you are interested in investing in five companies from a list of ten top performers across different industries, it becomes challenging to determine which five should be given preference. The criteria of leadership differ greatly from one sector to another, and this makes it difficult to compare companies in different sectors, such as the pharmaceutical and renewable energy sectors, each with its own set of unique issues and performance measures.
Additionally, this strategy may also focus on growth as a sign of progress instead of carrying out important sustainability evaluations. For instance, a young firm in the electric vehicle industry will be preferred due to growth prospects, though it negatively impacts the environment regarding the extraction of materials used in the production of batteries and disposal of such materials. This approach can lead to skewed investment decisions that focus on high growth rates as opposed to a holistic ethical performance and ESG influence across the value chain. Thus, industries could get too excessive support while the sustainability practices of those industries could be left unexamined, which may not be beneficial for the long-term sustainability goals.
Conclusion
Socially responsible investing is fast-growing and changing - with a wide range of options for how investors can invest (or not) in line with their ethical, sustainable values. Positive and negative screening, norms-based screening and leading performer screens are similar in implementation to SRI. However, there is no prescribed method for doing so that all investors must follow. As sustainability rises to the top of business priorities in 2024, investors will likely see more SRI tools and solutions when they look for ways to grow their portfolios. By understanding and then judiciously applying these strategies, investors can contribute to a virtuous cycle of positive social and environmental outcomes while possibly meeting financial objectives.
