Moneymentals | Our Blog
- Created on 01 April 2015
- Written by Michael Goldman
When you look at the companies within a mutual fund you’ve invested in, are you a proud supporter of each one? Or are there certain industries you’d rather not finance? Companies in a mutual fund don’t come a la carte. The closest you can get to being able to pick and choose is Socially Responsible Investing (SRI) — but the effect is still questionable.
When you invest in a mutual fund (a collection of securities from various corporations), you’re automatically helping to finance companies that do a variety of different things — some of which may not coincide with your values. Mutual funds for SRI are designed to eliminate what are often called “sin stocks.” That way, you can invest in a mutual fund that has companies you consider ethical and still receive monetary gains.
Sin Stocks and Your Values
Everyone’s values are different. Depending on who you are, making certain investments could mean you’re buying sin stocks. Oil companies, chemical companies, casinos, defense contractors, tobacco companies, wineries and pharmaceutical companies are some of the types of organizations that offer what could potentially qualify as sin stock for a person involved in SRI. The sin stock concept also applies to bonds, because a bond is essentially a loan you’re giving to a company.
The investing world doesn’t have a standard for what “socially responsible” is. To participate in SRI, you need to find an SRI mutual fund that fits your values.
SRI Funds: Usually Actively Managed
Mutual funds for SRI have to be actively managed. In other words, someone is paid to continuously decide which stocks to buy by applying social responsibility criteria as well as financial criteria to evaluate stock value and potential. My blog Easy Investing 101: What is Indexing? talks about the debate between passive and active fund management and the higher expense ratios that come with actively managed funds.
Index mutual funds are passively managed as opposed to the actively managed SRI mutual funds. With an index fund — and I’m a big proponent of indexing — you buy a slice of the whole market. You can’t eliminate certain companies from the mix, which usually includes oil companies, casinos, tobacco companies and so on because they’re among the largest companies in the world. However, index funds do have low expense ratios due to the sharp reduction in fees when active management is not required.
Your Tiny Impact as an SRI Participant
Foundations that grant money to charities first analyze the impact of a prospective grant. We can do the same by taking a close look at the effect of participating in SRI.
Let’s say you want to avoid Xyz Oil Company stock because you’re uncomfortable about how much pollution they dump into the environment every year. You decide to pass up a share of Xyz Oil at $100, refusing to buy it.
What impact does that have on Xyz Oil Company? A $100 billion company, Xyz Oil sees $100 as nothing, so in that sense your choice has virtually no impact. What’s more, when you buy a share of stock, you get it on the secondary market from the stock’s current owner. Xyz Oil wouldn’t know the transaction even happened, and the fraction of the company you’d own would be 0.000000000001. Obviously any effect you could achieve is just about nil.
However, would buying that stock help raise the share price so you end up supporting the Xyz Oil executives? No, because the only way to move the needle on a stock price would be to buy a lot of it — likely more than you could ever afford. To have an impact, you’d buy a massive amount of stock, become a major shareholder, fly to shareholder meetings, make a lot of noise and object to Xyz Oil Company’s policies. That’s called activist investing, and rarely do people have enough money to do it. You’d have to be in the top echelons of the uber-wealthy.
How to Really Make a Difference
What’s the true impact of refusing to buy a share of sin stock? It’s almost zero. Think about your values and what you’re trying to accomplish with SRI. Obviously you’re not having the desired effect by choosing not to invest in specific companies, because you just don’t have enough leverage.
Sure, $100 doesn’t mean much to Xyz Oil, but if you gave it to a local charity or political action group that supported your values, it can make a big difference. For example, some people don’t want to support military defense contractors. What would happen if you gave $100 to a charity that did humanitarian work in war-torn countries? Now that’s impact. Yet by giving the money away, you’ve lost your investment returns.
Measurable Returns with Measurable Impact
One of the big advantages of indexing is that the underlying expense is so much lower. For example, the Vanguard® Total Stock Market Index Fund (VTSAX) has an expense ratio of 0.05%. I searched recently for SRI-targeted funds in a similar category. One of the lower expense ratios I found was 0.87%. The difference is 0.82%. Other funds designed for SRI have ratios as high as 1.25%.
Folks interested in SRI don’t want to invest in index funds because they contain objectionable stocks, and they pay extra for SRI funds even though the impact is negligible. However, there’s a better way.
The alternative I suggest is what I call impact indexing. Impact indexing is simple: You invest in index funds, calculate your cost savings compared to SRI and give that savings the charity of your choice. I even do this myself.
Using our earlier example where there’s a 0.82% cost savings when you buy a standard index fund instead of a comparable SRI fund, imagine your investment portfolio has $100,000 in it. If you put the entire $100,000 into the index mutual fund instead of the SRI mutual fund, your yearly savings is 0.82% multiplied by $100,000, which is $820. Instead of giving that $820 to the SRI fund in the form of fees, you can maximize your impact by giving it to a cause you want to support. By the way, your contribution may even be tax deductible.
Impact Indexing and Your Conscience
You’ve got good intentions. You want to have a positive impact on the world and feel good about it. Impact indexing is another way of approaching socially responsibility that gives you real leverage instead of a nebulous influence that is almost imaginary.
With impact indexing, you’re acting according to your conscience in a strategic way that has far more impact than SRI. Although you’re still contributing in an infinitesimal way to companies you don’t approve of, you’re greatly offsetting that by using money to have a measurable effect on causes that matter to you.