Socially Responsible Index Investing: An Analysis Using The 5% Rule

by: Lowell Herr

Roger Nusbaum published an article on March 2 titled The Role Of Ethics In Portfolio Construction. His article reminded me of an analysis I conducted a few years ago to see what percentage of "sin" stocks actually exist in a portfolio made up from an array of index ETFs. Is it possible to be both an index and socially responsible investor?

I used guidelines from a non-profit organization that operates its portfolio using socially responsible standards. One of the guiding principles is that the portfolio may not hold a company that does more than 5% of its business in unacceptable or restricted areas. For example, if company ABC does more than 5% of its business in war related activities, that company is out of the portfolio. While organizations and individuals define unacceptable stocks differently, most "sin" stocks can be screened out of portfolios by eliminating tobacco, alcohol, gaming, and defense (war) oriented companies. Human rights, environmental concerns, treatment of women, birth control, and other issues require additional analysis.

To perform my analysis, I was able to obtain a list of unacceptable companies from one of the leading SRI screening services. I then took the Strategic Asset Allocation plan of the investment portfolio and assigned an ETF to each asset class. For example, 12% of the portfolio was assigned to Large-Cap Value. To populate that asset class I used Vanguard's ETF, VTV as the proxy.

Using Large-Cap Value as an example of what I did for each asset class in the portfolio, I listed all 350 stocks found in VTV. The number varies from time to time, but you get the idea. From among that group of 350 stocks I identified those that were found in the "no-no" list from the screened list. If tobacco stocks made up 1.9% of the VTV Exchange Traded Fund or Large-Cap Value, then 0.12 x 0.019 = 0.00228 or 0.23% of the total portfolio is holding tobacco. To purest, this is still unacceptable. If one drills into the weeds, not all tobacco stocks are pure tobacco. I did not dig that deep.

Running out this analysis for each asset class in accordance with the Strategic Asset Allocation plan of the portfolio, I found that approximately 2.2% to 2.4% of the portfolio would hold "sin" stocks if the portfolio were made up entirely from non-screened ETFs. Further, if one eliminated the Large-Cap Value ETF and selected individual stock in that asset class space, one could run that 2.4% down to something closer to 1.5% or well below the 5% limit permitted from an individual stock. Most unacceptable stocks, using the screened list I was given, fall in either the Large-Cap Value asset class or international markets.

The ethical question facing an index investor is the following. If it is permissible to hold an individual stock that does less than 5% of its business in areas considered unacceptable, is it permissible to build a portfolio using index funds or non-managed index ETFs where the total percentage of unacceptable investments is well below the 5% threshold? It is difficult to be a "pure" SRI investor whether one selects individual stocks or uses non-managed index ETFs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.