Can Couch Potatoes be socially responsible?

In my latest MoneySense column (see the June issue, not available online), I explored whether socially responsible investing is compatible with the Couch Potato strategy. If you’re not familiar with SRI, it’s about finding investments compatible with your ethics, which often means avoiding so-called sin stocks and companies with poor environmental records. It may also involve selecting investments that have a positive social impact.

My main source for that column was Timothy Nash, president of Strategic Sustainable Investments, a company that helps institutions and individuals create portfolios aligned with their values. Tim also has a blog called The Sustainable Economist and recently wrote a post called The Organic Couch Potato, where he shared his ETF suggestions.

Tim is a thoughtful, articulate advocate for SRI and I thought readers would like to hear more from him, so here’s an excerpt from our interview. I’ll run another in a few days, and next week I’ll go into more detail about specific investment products that combine passive investing with SRI principles.

In many ways passive investing and SRI seem incompatible. One of the fundamental ideas behind indexing is that you don’t pick individual companies. But with SRI, that is often what you’re doing.

TN: I actually see a lot of overlap between the two strategies, primarily in the sense that both are about long-term investing.

When it comes to choosing individual companies, I don’t think that’s what socially responsible investing is about at all. There are different approaches, and by far the most popular is negative screening. This started with religious communities that would exclude “sin stocks” like tobacco, firearms, and things like that. That has evolved to the point where the majority of socially responsible funds rank every company according to a sustainability score—the lingo we use is ESG, for environmental, social and governance. So every company will get an ESG score, and then the fund will drop the bottom 20% in each sector. This is the methodology used by the Jantzi Social Index, for example, and most of the SRI funds use a similar approach to that.

In some cases, rather than just dropping the bottom 20% they will have black list: if there has been a controversy, they will exclude that company. For example, Enbridge is excluded from the Jantzi Social Index because of the big oil spill that happened in Michigan in 2010. BP is another classic example: in fact, that company was in a number of SRI portfolios before the Deepwater Horizon oil spill, but as soon as that happened it was excluded.

Another strategy, which is important to many passive investors, is shareholder engagement. With traditional mutual funds you don’t go to the shareholder meetings yourself: you’ve got proxies, and the default policy is to simply vote with management. Let’s say there’s a shareholder resolution that would require the company to report their carbon emissions, and management says that’s a burden. Traditional investors will have their votes go with management against the resolution. Whereas with socially responsible investments, if they do shareholder engagement your vote will be used to push that company toward greater transparency, greater disclosure, greater sustainability.

Not all index funds do shareholder engagement: the iShares Jantzi Social Index Fund (XEN) doesn’t do it, but the US-listed iShares SRI funds do [These are the iShares MSCI Socially Responsible (DSI) and iShares MSCI Select Socially Responsible (KLD).] I’m really shocked the Canadian one doesn’t, because they are all iShares, and it’s all the same company, but the two funds in the US have a voting policy statement that says they will vote for any measure that promotes transparency and sustainability. I can’t tell you why the Canadian Jantzi ETF doesn’t.

What other strategies are used by SRI index funds?

TN: Another strategy is positive screening. With negative screening you get rid of stuff you don’t want: the worst of the worst. Positive screening is about including companies in sectors you do want. For passive investors there are a number of ETFs that follow what I would call green themes. There is a solar ETF, a wind ETF, and also a couple of water ETFs—as we move forward in a world that is experiencing climate change, I think water is going to become a huge issue. The one I put in my own Couch Potato portfolio is the PowerShares Cleantech Portfolio (PZD), which is diversified across a number of green themes.

The last strategy is called impact investing. This is a really hot topic right now in certain circles, but it hasn’t really made it into the mainstream yet. Impact investing involves going outside of financial markets and investing directly in projects that have both a positive financial return and a positive social or environmental impact.

One example is microcredit financing: that has been around for the longest. Another is community bonds, which are usually are centered around non-profit real estate. There’s a website called socialfinance.ca that follows a lot of these trends. They’re still very new and there aren’t many available, but it’s a very cool option for socially responsible investors because instead of SRI meaning you’re not going to invest in tobacco, military, and firearms, this is a way for investors to have direct impact and generate a financial return.