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Ideas for Socially Responsible Investing

Corporate social responsibility can make good business sense, but the investment options can be a little pricey

Alex Bryan 14 January, 2015 | 3:49PM
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In 1970, Milton Friedman famously wrote, "There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud." While that may seem like an extreme view, Friedman does have a point. As the owners of a firm, shareholders hire managers to act as their agents. When managers focus on profit maximisation, they also tend to maximise shareholder wealth. If they choose, shareholders can then donate part of that wealth to social causes that are important to them.

To the extent that managers pursue objectives other than profit maximisation, they may reduce shareholders' wealth and effectively substitute shareholders' priorities with their own. Profit maximisation also tends to promote efficiency and accountability. In the pursuit of their self-interest, firms usually allocate scarce resources to their most productive uses.

The trouble is that firms do not always bear the full social costs of their actions. Economists call these phenomena ‘negative externalities’. For example, a coal power plant that expels its waste into the atmosphere could increase the prevalence of acid rain and make the surrounding area less desirable to live in, potentially hurting property values. Because the power generating firm does not directly bear these costs (in the absence of regulation), it may produce more electricity from coal than is socially optimal. So a narrow focus on profit maximisation does not always lead to the most efficient social outcome.

There is also an argument that this focus can result in an unfair distribution of resources. Perceptions about fairness are very subjective, but they can have a big impact on a firm's image, and ultimately its profitability. For example, Nike (NKE) faced consumer boycotts in the 1990s for its suppliers' use of sweatshop labour. Even though the suppliers paid market wages in the developing countries where they operated, the conditions those workers toiled in and the compensation they received seemed unfair to many Western consumers, who used their purchasing power to express their discontent.

In order to mitigate these potential problems, many corporations have defined their corporate social responsibility more broadly than Friedman to include taking responsibility for their impact on the environment and social welfare even when there is no legal requirement to do so. While that is certainly laudable from a social perspective, an expansive view of corporate social responsibility may also be consistent with long-term profit maximisation.

In getting out ahead of environmental and social problems that their operations may create, companies may be able to stave off potentially onerous regulations and reduce political risk. A proactive approach can also reduce the risk of conflicts with non-government organisations and other advocacy groups that can hurt sales and damage the value of a brand. Mindful of this risk, Starbucks (SBUX) developed standards for ethically sourced coffee in partnership with Conservation International in the early 2000s. In accordance with these standards, it now sources most of its coffee from producers with independently-verified environmentally-friendly practices.

Many companies have actually built strong brands and competitive advantages with their corporate social responsibility programmes. For example, Whole Foods Market (WFM) caters to environmentally- and health-conscious consumers and commands premium prices for its organic products. Whole Foods' environmental stewardship is an integral part of its brand identity and contributes to its pricing power. Similarly, the environmentally-conscious production processes at Ben & Jerry's (part of Unilever (ULVR), and its image as a socially-responsible firm help it differentiate its products. To a large extent, the firm uses ingredients that have been Fairtrade certified, which offers farmers in developing countries above-market prices for their goods in order to promote better standards of living. Many consumers are willing to pay more for these products because they feel better about the way they were made. Because corporate social responsibility can influence how consumers perceive a brand and their purchasing decisions, the pursuit of social and environmental goals can serve a similar role to advertising.

In some cases, pursing these goals may also help reduce costs. For instance, by improving the energy efficiency of its manufacturing processes, Dow Chemical (DOW) has saved about $400 million from 2005 to 2013. It doesn't always work out that way. Firms must balance the costs of implementing these programmes against their benefits.

A strong reputation for social responsibility may help firms attract and retain better talent, which could further sharpen their edge. It's attractive to many people to be part of an organisation they can be proud of and to feel that their work is making a difference. Merck's (MRK) programme to end river blindness may have allowed it to attract scientists who would not have otherwise been available, according to a paper by Geoffrey Heal. This disease affected millions in Africa who could not afford the drug Merck developed to treat it. So Merck gave it away to those who needed it, which enhanced its reputation.

Because a firm's impact on the environment and social welfare can affect its brand, risks and ability to attract and retain talent, pursing social and environmental goals can promote sustainable and attractive profits over the long term. Companies that take a more holistic view towards corporate social responsibility may be less likely to take shortcuts to boost short-term profits at the expense of long-term opportunities than their less socially-conscious counterparts.

However, there is a risk that firms with an expansive view of corporate social responsibility might also have less accountability for their results. It is easy for a firm to claim it has a long-term view, but because the results do not materialise for several years, it's difficult to hold managers accountable for their immediate actions. Firms might also justify actions that are socially sub-optimal in favour of a preferred stakeholder. For instance, a firm may avoid necessary layoffs that would improve efficiency in order to support the community. But that firm may ultimately become less competitive and contribute less to society than it would have if it were more efficiently run. Good corporate governance is vital to prevent this type of waste and promote accountability. Fortunately, a few sustainable, responsible and impact investing funds, or SRI funds, incorporate governance into their stock-selection criteria.

Investment Ideas

Investors looking for a core holding that targets stocks with socially responsible characteristics might consider UBS MSCI UK Socially Responsible ETF (UKSR) or UBS MSCI World Socially Responsible ETC (UC44). Both screen for stocks with strong Environmental, Social and Governance ratings (ESG) relative to their sector peers. The UBS ETF providing exposure to socially-responsible UK stocks was only launched a few months ago and has an Ongoing Charge of 0.28%. The UBS ETF offering exposure to global socially-responsible stocks was launched three years ago and beat its Global Large-Cap Blend Equity category in both 2013 and 2014, helping it earn a 4-star Morningstar rating. This world equity fund charges 0.38%.

In addition to these ETFs, an index tracker that has earned a 5-star Morningstar rating is available in the form of Vanguard SRI Global Stock Fund, charging 0.35%. Note that SRI index funds tend to charge higher fees than traditional index funds. 

While SRI index funds passively screen for companies with strong ESG characteristics, their actively-managed counterparts, such as Aberdeen Ethical World Equity fund (rated Bronze by Morningstar) and Kames Ethical Equity fund (rated Silver), can use their relationships with portfolio companies to advocate for positive social change.

A unique feature of the Aberdeen management team’s approach is that there are no quantitative filters; they instead compile a global buy list of stocks recommended by their regional colleagues. Companies that fall out on social, ethical or environmental grounds are then replaced, where a suitable alternative can be found. At Kames, while manager Audrey Ryan concentrates on the investment process, we like the fact that the ethical screening process is separate and the responsibility of Ryan Smith, Head of Corporate Governance and SRI. Both these actively-managed funds come at the cost of an Ongoing Charge in excess of 1.5% for the retail share class.

Reference
Heal, G. 2004. "Corporate Social Responsibility—An Economic and Financial Framework." Columbia Business School, Working Paper

"Investment Ideas" section of this article was written by Holly Cook, managing editor of Morningstar.co.uk.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Alex Bryan  is an ETF analyst with Morningstar.