Socially responsible investment (SRI) is about investing in values. Socially responsible ETFs select companies based on political, social, environmental and corporate governance considerations. Can ethics and values be profitable? Or must investors forgo profits for the sake of their belief system?
Unethical behavior is not profitable. Accounting fraud, faulty risk management controls, and environmental sloppiness can send firms into bankruptcy. When companies are made responsible for injuries their products cause, shareholders are hurt. An ETF that comprised of companies avoiding these situations would be a winner.
But over the long term, some of the best performing investments are in sectors many investors find objectionable. Tobacco, alcoholic beverages, gaming machines, defense contractors, oil exploration and drilling companies are all often stellar performers. Investors in socially responsible ETFs must balance these realities.
There is no ultimate agreement about what constitutes socially responsible investment. SRI-focused ETFs take a variety of approaches to the challenge of investing in good without sacrificing financial performance.
One approach is to focus on a particular sector and invest in companies that develop alternatives to that sector. If the environment is a priority, for example, ETFs focusing on alternative energy are an option. There are many such funds. PowerShares WilderHill Clean Energy (NYSEArca:PBW) is one of the oldest and best established alternative energy ETFs.
On the other hand, there are traditional energy providers represented by ETFs such as the Energy Select Sector SPDR (NYSEArca: XLE). XLE holds major oil producers like Exxon Mobile and Chevron and oil service companies like Halliburton. Luckily for investors in XLE, there is little exposure to British Petroleum. PBW by contrasts holds companies that aim to be cost-competitive with fossil fuels but often are not yet competitive and therefore are partly or wholly dependent on government subsidy. These companies are much smaller than the major holdings in XLE. They do not have proven cash flows. They tend to be more volatile.
Another approach to socially responsible investment is to focus on the market as a whole but choose companies thought to have comparatively superior record of environmental, social and corporate governance relative to their peers in the same sector. iShares KLD Select Social Index (NYSEArca:KLD) takes this approach. It holds 200-300 companies chosen from the S&P 900 Index. The sector allocation is almost identical to the SPY benchmark so big energy companies for example are allowed. But KLD holds no tobacco stock and a smaller allocation goes to utilities and energy companies when compared with the benchmark.
For some investors the market-targeting approach taken by KLD is not ambitious enough. They point to KLD's small position in Halliburton, which was involved in the BP oil spill as well as a major contractor in Iraq as an example of deviating from socially responsible objectives.
These investors should take a look at the iShares KLD 400 Social Index (NYSEArca:DSI). DSI is at once more selective and more pro-active compared with KLD. It automatically excludes investments the SINdex-- tobacco, alcohol and gambling. It also excludes companies involved in weaponry and nuclear power. DSI overweights companies with strong environmental corporate governance and human rights records. Of course none of these considerations automatically keep Halliburton or Cameron International out of the portfolio-- at least prior to the BP oil spill.
Over the last decade alternative energy ETFs have mostly underperformed conventional oil and oil service funds, defense contractors and notorious carbon polluters in the power generation business. But this long-term trend may be under attack. Concern about the environment is heating up. Public disgust with corporate malfeasance is increasingly important. Environmentally friendly technologies are becoming more prominent and profitable. Socially responsible investment, when done properly, can bring strong returns.
Following is a list of ETFs with a focus on social responsibility:
Global Alternative Energy