Socially Responsible Investing

| About: iShares MSCI (KLD)

"Socially Responsible Investing" is a hot topic these days. Rather than searching for your own group of socially responsible companies in which to invest, a number of companies have built funds to address this growing market. Retired Investor's editor, Tom Coyne, discusses the iShares KLD Select Social Index Fund (ticker: KLD):

The launch in the United States of the iShares KLD Select Social Index Fund (ticker: KLD; .50% expense ratio) makes this an appropriate time to examine the logic behind what is known as "socially responsible investing."

When examining the logic behind socially responsible investing, the first, and ultimately the most difficult challenge one encounters, is defining what constitutes a "socially responsible" company.  Unfortunately, there is no general agreement on what this means. In general, classification as a "socially responsible firm" is the result of a two step process.  The first stage is a "negative screen" that eliminates companies that operate in certain, presumably "socially irresponsible" industries.  However, the firms that assign "social responsibility" ratings don't agree on which industries belong in this category. Moreover, these "negative screens" also raise questions about where to draw the line, so to speak.  For example, while tobacco companies are out, banks that lend to them can still be considered "socially responsible."  The same is true for the difference between chemical companies and companies in other industries that use chemicals as inputs into their production process.

The second stage of the "socially responsible" classification is a so-called "positive screen" that assigns points for behaviors and practices that, based on some criteria, are considered "socially responsible."  Unfortunately, there is no agreement on what these are.   For example, consider the differences in criteria used by two firms that assign social responsibility ratings to firms. One's list includes community relations, employee relations, workforce diversity, environment, human rights, and product quality and safety; the other's includes governance and ethics, safe and health work environment, environment, product safety and impact, international operations and human rights, indigenous peoples' rights, and community relations.  In addition, the process of assigning companies ratings on these criteria also tends to be highly subjective.

Assuming one has settled on a definition of the characteristics of a "socially responsible" company, the next question is whether there is any evidence that social responsibility (so defined) is associated with superior risk adjusted returns.  Perhaps the strongest evidence is found in the area of corporate governance. Multiple academic studies have found a significant positive relationship between good corporate governance and higher shareholder returns.  However, social responsibility screens also include many criteria with no demonstrated relationship to superior financial performance. 

There is no shortage of socially responsible indexes available today, from both global providers (e.g., the Dow Jones Sustainability Indexes and the FTSE4Good indexes), and national or regional ones (e.g., the Calvert and KLD/Domini indexes in the United States). 

The most common weighting approach used is market capitalization. If one believes that socially responsible companies will generate superior risk adjusted returns, then market capitalization weighting maximizes the financial benefit to an investor. However if you believe that corporate social responsibility is valuable in its own right, even if it results in lower financial returns, then one should logically use a weighting scheme based on companies' "social responsibility" scores.

The KLD Select Social Index (upon which the iShares ETF is based) uses a variant of this approach. Its weighting scheme maximizes the social responsibility score of its constituent companies, subject to the constraint that its expected return cannot deviate by more than 2% from the Russell 1000.