What is socially responsible investment (SRI)? How to build a SRI portfolio?

Socially Responsible Investing (SRI), once considered a niche strategy, is now at the forefront of modern investment practices. What is SRI? And why is it gaining traction?  Explore SRI, a powerful way to align financial decisions with ethical beliefs. Understand how SRI differs from traditional investments, its principles, advantages, performance, and trends in India.
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Socially Responsible Investing (SRI) represents a dynamic intersection between financial goals and personal values. With its growing popularity and accessibility, SRI offers a viable investment pathway for those seeking to align their financial decisions with their ethical beliefs. In an age where society is increasingly conscious of its impact on the world, SRI provides a means for individuals to put their money where their morals are. Whether you're concerned about environmental stewardship, human rights, or community development, SRI offers a way to invest in line with those values. Socially Responsible Investing (SRI), once considered a niche strategy, is now at the forefront of modern investment practices. What is SRI? And why is it gaining traction?

What is Social Responsible Investment- SRI?

Socially Responsible Investing (SRI) aims to achieve both social change and financial returns. It's about investing in companies that make a positive impact and excluding those with a negative one. SRI is known by several names, such as values-based investing, sustainable investing, and ethical investing. It has even evolved to include sustainable, responsible, and impact investing. It has also become synonymous with ESG investing which accounts for Environmental, Social, and Governance factors, helping investors align their portfolios with their values - more on the differences between ESG & SRI a little later.

We can trace the roots of SRI back to the 1700s in the United States, when groups like the Quakers denounced the slave trade. John Wesley, another US historical figure, opposed profiting at the expense of others' welfare. While there are many such examples throughout time and history, to truly understand what SRI is about we need to introspect and figure out our own personal values first.

Understanding SRI in detail

Investors interested in SRI look beyond typical metrics like performance and expenses. They consider whether a company's revenue sources and practices align with their personal values. Since values vary widely among individuals, SRI can take many forms. For example, if you care about the environment, you might invest in wind or solar companies. If social justice is your passion, you may choose mutual funds that invest in women-run or minority-owned businesses.

SRI covers a broad spectrum of concerns:

  • Environmental Impact: Climate change, conservation, pollution control, etc.

  • Human Rights: Fair labor practices, equal opportunities, etc.

  • Community Relations and Development: Supporting local businesses, community engagement, etc.

  • Consumer Protection: Ethical marketing, product safety, etc.

  • Corporate Governance: Transparency, accountability, ethical leadership, etc.

However, not all SRI funds are the same. Each fund has it's own values and screening mechanisms that may not align with an investor's morals/ values. For example Vanguard’s VFTSX fund, though screened for ESG criteria, includes stocks from companies like Amazon and Facebook. Some SRI investors may have values that go against the practices undertaken by large MNCs and hence might prefer to avoid them. So, identifying such companies and SRI Funds is important.

Benefits and Advantages of SRI

1. Invest in Funds that Align with Your Values

Investors can use SRI Funds to invest in companies and projects that closely align with their values and ultimately what they believe in. For instance, investors could align to gender equality, climate change, sustainability, social justice and can use SRI to find companies that also value such goals and objectives. Beliefs that do not align or contradict with their beliefs, can be ignored and avoided. And the investor will create a portfolio that embodies their personal ethics.

2. Opportunity to Reward Ethical Companies

Investing in ethical companies can lead to significant change by strengthening responsible businesses and depriving unethical ones of capital. A prime example of this is Lego's shift from a partnership with Shell Oil to collaboration with socially responsible organizations like the World Wildlife Foundation.

3. Sense of Fulfillment

Investors in SRI feel a profound sense of accomplishment in contributing to a better world. This is a rewarding feeling that goes beyond financial gain.

4. De-Risking your Portfolio

In a world shifting towards sustainability, companies that lack social responsibility may face long-term risks. Investing in SRI now can be a strategic move to avoid these risks in the future.

5. Invest According to your Values

SRI allows investors to create a portfolio that precisely aligns with their core values, fostering investment in companies that support their convictions.

6. Helps Bring Desirable Change on the Planet

Collective investment in SRI can lead to tangible societal and environmental impacts. Reducing investment in harmful industries and supporting alternatives can indeed make a positive change in the world.

Downsides of SRI Portfolio

1. Potential to Forego Greater Investment Opportunities

An exclusive focus on SRI may limit access to other potentially lucrative investments, even if those opportunities come from less socially responsible companies.

2. Limited Investment Opportunities

Since a strong SRI approach may rule out many companies, investors might find a more limited pool of investment opportunities, potentially hindering financial returns.

3. Not all Companies are What They Seem

Some companies falsely claim social responsibility for publicity or to avoid criticism. This can mislead investors and dilute the true impact of their investments.

4. Ethics Might Overshadow Performance

A company excessively focusing on social responsibility might neglect performance. While ethics are crucial, a balance with performance is necessary to maintain profitable returns.

How Is SRI Different from ESG?

Though sometimes used interchangeably, SRI and ESG are distinct investment strategies. While they share common goals of promoting ethical and sustainable investment practices, they differ in their methodologies and primary focuses.

What is ESG?

Unlike SRI, ESG investing takes a financial materiality approach rather than focusing solely on specific values when selecting securities. ESG serves as a risk-mitigation strategy, where investors evaluate a company's future performance based on its environmental, social, and governance practices. For instance, inadequate treatment of employees could lead to labor strikes, while poor waste management might result in fines or government regulations.

By integrating ESG research with conventional financial analysis, a more comprehensive perspective of investments emerges, facilitating the identification of associated risks and opportunities. This strategic approach doesn't necessarily guarantee positive ESG outcomes or restrict the investment scope, but it introduces additional dimensions into the security selection process, enhancing its holistic nature.

SRI vs. ESG, and how are they different?

SRI is a subset of responsible investing that places a stronger emphasis on aligning investments with specific social or ethical values. SRI investors typically avoid companies or industries that conflict with their values, such as those involved in tobacco, weapons, or fossil fuels.

Unlike ESG investing, which looks at a broader set of factors, SRI is often driven by personal or group values and aims to avoid investments that are considered harmful or ethically questionable.

SRI (Socially Responsible Investing)

ESG (Environmental, Social, Governance)

Filters out sectors considered unethical or socially detrimental.

Supports companies promoting wellness in the environment, society, and ethical practices.

Investors can decide based on their personal values what they want to invest in such as health, social, governance etc.

Investors have to focus on 3 main factors - Environmental, Social and Governance

Balances profits on returns against socially responsible factors.

Aims to produce returns on investments.

Suitable for single-issue investors.

The criteria enhances financial analysis.

Excludes companies dealing with controversial sectors like alcohol, petroleum, gambling.

No specific category or cap on the number of investors.

SRI uses ESG factors for decisions, but the focus is more on ethical filters, while ESG integrates these aspects for broader financial considerations.

Building a Socially Responsible Investment Portfolio

There are many ways to make socially responsible investments, whether it is a DIY approach or via an advisor/ fund. These approaches can be classified into 3 broad categories:

1. Negative Screening

This involves avoiding investment in companies that engage in practices contrary to the investor’s values.

  • Identify and exclude companies involved in harmful activities like weapons, tobacco, gambling, fossil fuels or unethical practices.

  • In essence, avoid buying stocks of companies that are not socially beneficial.

2. Positive Investing

Positive investing focuses on actively supporting companies that engage in positive social and environmental activities like financial inclusion, decarbonization, or women empowerment.

  • Identify and include companies that align with particular social or environmental concerns, like eco-friendly policies.

  • Research independent ratings from firms like Morningstar to gauge a company’s sustainability practices.

3. Community Investing

Investors may channel funds into local projects or initiatives that aim to uplift and economically fortify local communities.

In all three the approach to investment decision making is ultimately guided by personal values and the broader societal impact of the company. Let’s see how we can build an SRI Portfolio.

How to Build an SRI Portfolio

1. Decide the Level of Assistance Required

  • DIY approach: Choose your investments, monitor them over time, and apply specific exclusionary and inclusionary criteria.

  • Robo-advisors: Utilize algorithms for a hassle-free investment approach.

2. Open an Investing Account

Choose a brokerage that supports SRI

3. Outline the Values

Clearly define the ethical boundaries to ease the selection process.

4. Research Carefully

  • For stocks, review company sustainability reports, board diversity, etc.

  • For mutual funds, utilize screening tools or specific focus areas like fossil-fuel-free investing. Always consider the expense ratio for mutual funds.

Downsides of Building Your Own SRI Portfolio

  • Potential Underperformance: Excluding certain sectors may lead to underperformance if those industries experience growth.

  • Lack of Alignment: Exclusion does not necessarily mean alignment with your values.

  • Complexity: Building an SRI portfolio may require a comprehensive analysis of ESG factors, which can be complex.

Overview of Socially Responsible Investment in India

The global landscape of ESG investments is expected to reach a staggering $33.9 trillion by 2026. In India, over 64% of investors are set to increase their exposure to sustainable funds this year, despite widespread accusations of greenwashing. Furthermore according to the FIS’2023 Global Innovation Report, 60% of financial firms are designing ESG products. This underlines a remarkable growth trend, where India has been an active participant in the ESG investment revolution.

However, ESG and SRI is still at a nascent stage in Indian markets. First ESG focussed funds were launched in 2019/20. We have seen a surge of ESG investing in India.

Challenges Faced by the ESG Sector in India

1. Lack of Standardization and Accusations of Greenwashing

The rapid growth in ESG investments has been accompanied by significant challenges. A lack of standardized regulations, reporting, and data collection has allowed some companies to use deceptive tactics to mislead customers. Disparate data sources have also raised concerns about the meaning, quality, reliability, and timeliness of the information, shaking investor confidence.

  • In S&P BSE 100 ESG Index, 22 out of 53 companies are rated above 30 by Sustainalytics of which 5 are rated above 40. 30-40 can be interpreted as high risk and 40+ is severe risk.

  • ESG focused mutual funds invest in 161 constituent universe of which 78 scored less than 60 on a 100 point scale by Crisil.

2. Regulatory Concerns

Despite multiple ESG rating frameworks approved by SEBI, none have been standardized across the spectrum, leading to subjectivity and bias. The need for a specialized, standardized ESG framework to rate bond issuers and restore investor confidence is a prominent concern.

3. Technological Issues

The massive data and integrity challenges in ESG investing need technological solutions. However, the complexity and diversity of the information have hindered the utilization of technology.

Solutions and Intervention

The concerted efforts from regulators, financial institutions, and fintech firms are paving the way for a more transparent and robust ESG investment environment in India. Companies are now investing in technology to enhance their ESG reporting capabilities, and regulations are being fine-tuned to promote transparency and sustainability.

1. Regulatory Measures

  • Standardized ESG Framework: SEBI has welcomed standardized frameworks like BRSR notification which has 9 major ESG attributes for disclosures. These frameworks set strict mandates for ethical practices in ESG advertising, disclosures, and reporting, allowing more control and transparency for investors.

  • Sovereign Green Bonds: Approved in November 2022, these are focused on encouraging green investments in India.

  • SEBI's Circular on ESG Ratings: SEBI’s guidelines for ESG rating providers aim to foster an ESG-conscious ecosystem, with innovations such as the Parivartan score that incentivizes transition finance.

  • Mutual funds: Guidelines permit mutual funds to launch multiple ESG-oriented funds with specific strategies, allocating at least 80% of their corpus to the chosen strategy.

2. Technological Innovations

  • Artificial Intelligence (AI) and Machine Learning: These technologies are transforming how ESG information is processed, making it easier to comprehend and apply.

  • Distributed Ledger Technology (DLT): Blockchain and other DLT can simplify the structuring, issuance, and distribution of green bonds, reducing costs, enhancing transparency, and cutting down fraudulent activities.

How have SRI/ ESG performed?

The global ESG investment landscape is projected to reach $33.9 trillion by 2026, reflecting a significant growth in interest among investors, with the number of sustainable open-ended mutual funds and ETFs rising from 111 in 2014 to 303 in 2019.

Although there have been concerns in the past about SRI limiting investment returns, recent evidence contradicts this skepticism. A 2020 analysis by Arabesque Partners revealed that sustainability practices positively influenced investment performance in 80% of the reviewed studies. Moreover, other research has found that SRI mutual funds can not only compete with, but sometimes outperform traditional funds, with potential for less volatility, indicating that SRI is not only morally appealing but can also be financially advantageous.

Here are a few interesting excerpts from a recent study conducted by Ved Beloskar & S. V. D. Nageswara Rao on “Did ESG Save the Day? Evidence From India During the COVID-19 Crisis.”

…Over the period 1996 to 2013, during the crisis and post-crisis period, socially responsible stocks portfolio generated. significantly higher returns than other portfolios in the Indian stock market. The compromise made with respect to diversification by investing in socially responsible stocks portfolios was well rewarded in the form of higher returns (Tripathi & Bhandari, 2015)...

…The massive correction in equity markets across the globe and the resultant volatility during the COVID-19 pandemic reflected a strong negative investor sentiment. However, this sentiment was less observed in ESG stocks. ESG fund flows across the globe were strongly positive and breached their previous records during the pandemic…

…ESG scores are positively associated with cumulative returns during the COVID-19 crisis. Thus, firms with high ESG scores perform relatively well during crisis periods, thereby serving as “rainy day assets” for investors. investors in high ESG stocks may identify ESG performance as a signal of future stock performance and downside protection in crisis times…

…We also establish an important negative relationship between stock return volatility and ESG scores during crisis periods…

Concluding Thoughts

Socially Responsible Investing (SRI) is more than just a financial strategy; it's a reflection of personal values and a tool for positive change. Its rising popularity attests to a growing desire among investors to put their money to work in ways that resonate with their beliefs. From its historical roots to its contemporary surge in India and around the world, SRI is no longer a niche practice. With proven financial performance and the power to make a real-world impact, SRI is at the forefront of a new era in investing. Embracing SRI means contributing to a more sustainable and ethical world while also paving the way for financial success. Whether you're an experienced investor or just starting, the convergence of ethics and economics in SRI offers an exciting and rewarding path.

Check out this article on Why we are bullish on the India Growth Story? Insight into India's Economic Surge, Stock Market Growth & Future Prospects

FAQ

1. Is Socially Responsible Investing Profitable?

Yes, Socially Responsible Investing (SRI) can be profitable. Recent studies have shown that SRI can compete with, and sometimes outperform, traditional investment funds. Investing in SRI doesn't necessarily compromise financial returns, and sometimes it leads to less volatility.

2. How does SRI differ from traditional investment approaches?

SRI differs from traditional investment approaches by emphasizing ethical and social factors in addition to financial returns. Investors align their portfolio with their personal values, such as environmental stewardship or social justice, and avoid companies that conflict with those values. Traditional investment approaches focus primarily on financial returns and risk.

3. What are the key principles and criteria for socially responsible investments?

Key principles for SRI include:

  • Environmental Impact: Considering companies' effects on climate change, conservation, pollution control, etc.
  • Human Rights: Evaluating fair labor practices, equal opportunities, etc.
  • Community Relations and Development: Supporting local businesses, community engagement, etc.
  • Consumer Protection: Assessing ethical marketing, product safety, etc.
  • Corporate Governance: Looking into transparency, accountability, ethical leadership, etc.

4. What are the advantages of incorporating SRI in my investment portfolio?

The advantages of incorporating SRI include:

  • Investing in alignment with personal beliefs and values.
  • The opportunity to reward ethical companies.
  • A sense of personal fulfillment.
  • The potential for de-risking your portfolio from long-term societal shifts.
  • Helping to bring about desirable change on the planet.

5. Can I achieve financial returns while investing in socially responsible funds?

Yes, you can achieve financial returns while investing in socially responsible funds. Studies have shown that SRI funds can compete with traditional funds and that they do not necessarily compromise financial performance.

6. What resources or tools are available for researching and monitoring SRI investments?

Resources for researching and monitoring SRI investments include specialized research firms, ESG rating agencies, financial advisors with SRI expertise, mutual fund companies offering SRI options, and online tools and platforms that screen investments based on ESG criteria.

7. Is socially responsible investing popular in India? What are the trends?

SRI is gaining popularity in India, with over 64% of investors set to increase their exposure to sustainable funds. There has been a surge in ESG investing in India, especially since the launch of the first ESG-focused funds in 2019/20. Challenges exist, such as lack of standardization and greenwashing, but concerted efforts are paving the way for a more transparent and robust ESG investment environment.