Socially Responsible Investing

For many investors, the endgame is to do good, feel good, and generate wealth at the same time. Intrigued? Read on to learn about socially responsible investing.

What is socially responsible investing (SRI)?

Socially responsible investing, or SRI, is an investment strategy that focuses on companies making positive social impacts while producing adequate financial returns. In practice and definition, SRI is related to ESG investing, which is an investment approach that considers, alongside traditional financial analysis, a company's record on environmental sustainability, social sustainability, and corporate governance.

While the terms ESG and SRI are sometimes used interchangeably, most investors distinguish the SRI approach as being stricter with respect to expectations for the company's positive social impact. Below are four key points to know about socially responsible investing.

1. SRI excludes companies participating in controversial industries.

Unsavory activities such as gun manufacturing, tobacco production, gambling, nuclear power, adult entertainment, and predatory lending are typically categorically excluded by socially responsible investors. The exclusion of entire sectors is known as negative screening.

2. Socially responsible investors use the ESG framework for evaluation.

For companies that pass the negative screens, the socially responsible investor evaluates the company based on its performance relative to environmental, social, and governance criteria. 

Companies manage their environmental risks with initiatives that improve resource efficiency and reduce waste. Companies improve social outcomes by treating employees well and having positive interactions with the local community. Companies with strong corporate governance prioritize board independence, increase reporting transparency, align executive compensation with company performance, and establish strong shareholder rights.

3. Socially responsible investors don't sacrifice financial returns.

SRI is responsible investing, not philanthropic giving. Socially responsible investors expect their holdings to generate returns.

4. SRI benefits investors — and everyone else.

Socially responsible investors see no reason to choose between investing in companies that are financially sound and protecting people and the planet. SRI can build wealth while making the world a better place.

Image source: Getty Images.

How to build an SRI portfolio

You can use these four steps to find socially responsible investments that meet your personal SRI criteria.

1. Define your SRI objectives.

The search for the right companies or funds can be overwhelming if you're not sure what types of socially responsible activities you want to prioritize supporting. You may want to fund companies that are strong in all three categories of ESG, or just one of those categories could be your priority. There's also the option to put your money into certain causes, ranging from climate change to animal rights, or specific business activities, such as solar energy.

An important step here — perhaps your first step — is to define your own negative screens to eliminate the sectors and activities you don't want in your portfolio.

2. Review SRI indexes and funds.

Whether you want to buy individual stocks, shares of ETFs or mutual funds, or a combination, you can get investment ideas by reviewing the components of SRI indexes and the holdings of mutual funds and ETFs. You can also look at these indexes' and funds' negative screens. Investing in mutual funds and ETFs confers the benefit of instant diversification and lower portfolio volatility.

3. Check multiple sets of ESG ratings.

If you want to pick individual stocks, you should review the company's annual ESG reports. But you should also validate ESG performance by reviewing third-party ESG rankings. MSCI and Sustainalytics both produce searchable ESG ratings. 

MSCI ratings range from AAA to CCC and are grouped in three tiers: leader, average, and laggard. The leader tier includes AAA and AA ratings. Average ESG performers have A, BBB, or BB ratings. The laggards — companies that are not managing ESG risks — are ranked B or CCC. You can search MSCI ratings by company name or ticker. You can also search for MSCI ratings on funds.

Sustainalytics has a five-tier rating for ESG risk. A company is given a numerical score based on its risk exposure and how well that risk is being managed. A low number equates to low risk, while the highest numbers represent severe risk. You can search for companies by name to find their ESG rating.

4. Remember the other asset classes.

Your SRI portfolio doesn't have to be composed entirely of stock. You can also invest in socially responsible fixed-income securities. Investing in mutual funds and ETFs is the most efficient approach, and the iShares Global Green Bond ETF (BGRN -0.19%) is another ETF example.

Stocks for socially responsible investing

Fortunately for the socially conscious investor, some of the country's largest and most successful companies have strong sustainability track records. That means investors don't have to sacrifice investment quality to build portfolios that align with their values.

The table below shows seven large-cap SRI stocks, along with the company's 10-year financial return and ESG ratings from two sources. For the MSCI rating system, an AAA rating is the best, and for the Sustainalytics rating system, a low number equates to low ESG risk.

Data sources: Morningstar, MSCI, Sustainalytics.

The most demanding socially responsible investors want to see more than high ESG ratings, however. Known as impact investors, they want measurable results from a company's business activities and social programs.

Most impact investing is done by hedge funds and private equity firms. But there are mutual funds and exchange-traded funds (ETFs) that also allow individual investors to pursue impact investing.

One example is the iShares MSCI Global Impact ETF (SDG -0.80%). This ETF invests in companies that earn most of their revenue from products or services that actively support one of the U.N.'s 17 Sustainable Development Goals, which are related to poverty, clean water, clean energy, education, gender equality, and climate change. Electric carmaker Tesla (TSLA -4.95%) and wind turbine company Vestas Wind Systems (VWDRY -1.30%) are both top holdings in the fund's portfolio.

How profitable is socially responsible investing?

There's a growing body of evidence supporting the theory that SRI is good for your portfolio. Companies with strong ESG track records almost always perform at least as well, if not better, than their less-sustainable peers. ESG-focused companies also tend to be more resilient in market downturns.

Socially conscious investing is on the rise. Investors are increasingly aware that they can use their money to effect positive change — and without sacrificing financial returns. Companies, too, are recognizing the many advantages of good corporate citizenship. It's a win for everyone involved.