Some people think that investment and ethics are best kept apart. But an increasing number of people are putting their money into investments that are screened based on ethical principles. In this article we focus on Socially Responsible Investment (SRI) funds which are "best" in that their management fee is low, they are large and therefore likely to be around for a while, and they are exchange traded funds (ETFs) that trade on the London Stock Exchange.
The fact is that if you have money you are implicitly taking an ethical stance. If it's cash in the bank then you are providing cheap funding for your bank. Do you really want to make your bank richer? If you have a pension then your pension will invest in stocks and bonds on your behalf and you will be providing equity and bond funding for the companies and governments whose assets they buy. Capital is never ethically neutral.
How does SRI investing work?
The funds we are considering are passive, which means that they copy a stock index. So the place to look for the "ethics" is not in the fund itself but the index which it tracks. The two approaches are to take a standard index, such as the S&P 500, and remove stocks that are not consistent with a given set of SRI principles, a process called "negative screening". Alternatively the index constructing company can use "positive" screens that may start off with an index but add shares outside the index based on SRI principles.
We will look at one UK Socially Responsible Index in detail: the MSCI United Kingdom SRI Index. MSCI is a company that produces indices and they do the hard work of screening stocks according to SRI principles for inclusion or exclusion from the index.
The first misconception to get out of the way is that SRI funds will underperform their non-SRI counterparts. In fact over the period from 2007-2017 the socially responsible version of the MSCI UK index outperformed the standard MSCI UK index. A statistical analysis by Deutsche Bank Asset and Wealth Management ("ESG & Corporate Financial Performance:Mapping the global landscape") showed that companies which adhere to MSCI's yardstick of "good" principles perform better financially than companies which do not.
Source: MSCI
The place where SRI becomes controversial is the subjectivity of what is and is not socially responsible. For example, MSCI excludes companies involved in the following activities:
Excluded by MSCI: Nuclear Power, Tobacco, Alcohol, Gambling, Military Weapons, Civilian Firearms, GMOs and Adult Entertainment
You may be looking at some of those categories and thinking, why is that excluded? For example nuclear power and Genetically Modified Organisms are, in my opinion, okay if properly regulated. In the US the five million members of the National Rifle Association would question the exclusion of civilian firearms. Members of the armed forces may question the exclusion of companies that produce military weapons. This highlights the problems of a pre-canned investment package: it won't be appropriate for everyone. If you don't agree with it, don't buy it! You can always buy individual stocks and bonds which are in line with your own principles.
Although, on the face of it, MSCI's exclusions may seem arbitrary they have an elaborate and well-structured approach to determining which stocks comply with socially responsible principles. They base their approach on Environment, Social and Governance (ESG) Ratings. They employ thousands of analysts to rank companies according to 37 issues feeding down from the three "pillars" of Environment, Social and Governance, and this is an ongoing process. A company that scores well this year may improve or deteriorate its ESG rankings over time and this could mean the index components change over time. As SRI indices become more popular slipping out of the SRI index could mean the stock price suffers, and so over time the effect of these rankings will increasingly reward companies that adhere to the ESG principles and punish those who do not.
MSCI UK Socially Responsible Investment Index
This table shows that there are 109 stocks in the raw MSCI UK index but only 38 make it through the screening process. The process of reduction has to be conducted carefully because it can concentrate risk in a few stocks or sectors. Say we had an index with just two sectors: 50% in energy stocks and 50% in tech stocks. If many of the energy stocks are removed for the SRI version of the index we would create a lop-sided tech-heavy index. This could increase the risk of the index because it removes cross-sector diversification, so MSCI ensure that, as much as possible, the weight in each sector is not too high. You'll see that the largest weight for a single stock is 11.5% in the SRI index but just 6.9% for MSCI UK for the same reason.
Source: MSCI
Despite the best efforts of MSCI, as a result of the screening process you will notice some large differences in the sector composition of the SRI index. The UK is tricky because it has a much smaller stock market than the US so the choices are much more restricted. For example there are far fewer energy stocks (0.5% in the SRI index vs 14% in the original index) and more Telecoms stocks (17% in the SRI index vs 4.5% in the original index).
MSCI UK Sector Weights (Source: MSCI)
MSCI UK Socially Responsible Index Sector Weights (Source: MSCI)
You can see the concentration effect clearly if you look at the top ten largest stock holdings in each index. The reason why telecommunications has a 17% weighting in the SRI index is largely due to Vodafone which on its own makes up 11.5% of the index, but is only 2.9% of the main UK index. The second-largest constituent of MSCI UK is British American Tobacco which is excluded.
MSCI UK Index Top 10 Constituents (Source: MSCI)
MSCI UK Socially Responsible Index Top 10 Constituents (Source: MSCI)
What are the fees for SRI ETFs?
Although you may invest in SRI funds to reward companies that behave ethically you probably don't want to line the pockets of fund managers as well. So the goal of finding funds with low management fees is just as important in SRI investment as it is for normal investment. Here we list some of the largest ETFs by assets under management that are listed on the London Stock Exchange:
Exchange Traded Fund Name | Total Expense Ratio % | Currency | Net Assets (million) |
|---|---|---|---|
UBS-ETF MSCI North America Socially Responsible | 0.33 | GBP | 325 |
UBS-ETF MSCI World Socially Responsible | 0.38 | GBP | 242 |
UBS ETF MSCI Europe & Middle East Socially Responsible A | 0.28 | GBP | 219 |
UBS ETF - MSCI Emerging Markets Socially Responsible UCITS ETF | 0.53 | GBP | 202 |
UBS ETF MSCI UK SRI A-Dis | 0.28 | GBP | 98 |
UBS ETF MSCI Pacific Socially Responsible A | 0.4 | GBP | 42 |
iShares Sustain MSCI EM SRI UCITS ETF | 0.35 | GBP | 31 |
iShares Sus MSCI Japan Sri Eur Hedged | 0.35 | EUR | 24 |
iShares Sustain MSCI USA SRI UCITS ETF | 0.30 | USD | 16 |
iShares MSCI Japan SRI UCITS ETF USD Acc | 0.30 | USD | 6 |
You'll see that the expense ratios are in the range of 0.33% per year to 0.53% per year. That means that if you invest £10,000 in one of these funds you will pay a management fee of between £33 and £53 per year which is in the mid-range to upper-range for passive ETFs. The fee reflects the ease and cost with with the fund manager can buy the shares for that fund. Emerging market shares tend to trade in smaller sizes and have a larger difference between their buying and selling price. This is passed on in fees, which is why the EM SRI funds tend to be more expensive than the others. We did find other funds with fees far above 1%, but you should think hard about paying that much given the other choices on offer for less.
Notice that we've listed the currency in which each ETF is traded because that adds another layer of risk to a fund. If the value of sterling fluctuates vs euros or US dollars then an ETF that is denominated in one of those currencies will fluctuate too for a UK investor. This is a hidden risk you should be aware of before buying a non-sterling fund.
Religious Principles
Ethics are usually linked to our religious beliefs and so the fund management industry has responded with funds that invest in line with religious beliefs. For example iShares offers three Islamic ETFs. The manager of iShares funds, a company called BlackRock, has a Shari’ah Panel which they describe as "a panel of Islamic scholars appointed to provide guidance relating to the Fund’s compliance with Shari’ah principles". The result is under-exposure to consumer discretionary stocks such as alcohol and tobacco related companies, and over-exposure to energy companies and oil companies. The largest of the three funds invests in shares globally, and the other two invest in stocks in the US and Emerging Markets. However these come with fairly high management fees and all three are traded in US dollars which poses a currency risk for non-US investors.
Exchange Traded Fund Name | Total Expense Ratio % | Currency | Net Assets (million) |
|---|---|---|---|
iShares MSCI World Islamic UCITS ETF | 0.60 | USD | 127 |
iShares MSCI USA Islamic UCITS ETF | 0.50 | USD | 35 |
iShares MSCI EM Islamic UCITS ETF | 0.85 | USD | 28 |
Other religions are not well represented in the SRI space. There is a Catholic Values ETF (ticker "CATH") that has net assets of $94 million with a Total Expense Ratio of 0.39%. This "provides exposure to the companies within the S&P 500 whose business practices adhere to the Socially Responsible Investment Guidelines as outlined by the United States Conference of Catholic Bishops (USCCB) and excludes those that do not".
Some SRI funds inevitably cause controversy if they exclude stocks that are involved with people holding contrary beliefs. One example is the "biblically responsible" ETF with ticker "BLES", managed by a small investment company called Inspire based in California, which says the following in its prospectus:
The methodology removes from the investment universe the securities of any company that has any degree of participation in activities that do not align with biblical values, which are: abortion, gambling, alcohol, pornography, the LGBT lifestyle and rights violations such as association with or doing business in terrorist sponsoring countries, countries having oppressive systems of government, and countries where there are known human rights violations related to the persecution or severe discrimination against Christians, and poor labor practices
The corporate world is generally growing more inclusive, with companies such as Goldman Sachs, Apple and many others allowing employees to state their sexuality without fear of negative repercussions. Companies are also supporting LGBT events such as the annual Gay Pride March in New York. These companies will be excluded from this index, and this provoked the anger of the LGBT community who see this as discrimination.
So which is best?
Well, it depends... primarily on your beliefs and your investment goals. If you agree with the screening process provided by MSCI's ESG research department then the cheapest ETFs in terms of ongoing fees are the UBS MSCI UK fund and the UBS MSCI Europe & Middle East Socially Responsible fund which both charge just 0.28% per year. And if you are willing to invest in risky Emerging Markets iShares has a Sustain MSCI EM SRI fund which charges 0.35% per year. If you want to invest according to Shari'ah principles management fees seem to be rather high, and the cheapest fund we have found is the iShares MSCI USA Islamic ETF which charges 0.50% per year. Please tell us if you have found cheaper alternatives.
Given the subjectivity of SRI investing we would suggest the following approach:
- Review your own beliefs and investment goals.
- Take a look at some SRI frameworks, such as MSCI's Environment, Social and Governance ratings system and see whether it is in sync with your own beliefs.
- Find a system that is in line with both your own beliefs and your investment goals. It may not exist...
- Remember it's okay not to agree with SRI principles! Like the majority of people you may be happy to invest in standard funds and lobby based on your own principles outside the investment arena.
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