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The Do-Good Investor: How Moral is Your Portfolio?
July Market Report

John Gorlow | Aug 12, 2017
This month we take a look at socially responsible investing (SRI), which taps into the idea that we can make morally defensible choices with our investments. Who wouldn’t want a portfolio packed with ethically-minded companies that protect people and the environment? But not so fast. When an industry that wants your investment money also plays judge, jury and scorekeeper, it’s wise to ask a few questions before following the herd. But first, a quick look at July markets.
July Market Report
(with thanks to DFA)

World Asset Classes
Looking at broad market indices, emerging markets (+5.96%) and non-US developed markets (+2.98%) recorded positive returns, outperforming the US marketwide index (+1.89%) during the month. The value effect was negative in the US and emerging markets but positive in the non-US developed markets. Small caps underperformed large caps in the US and emerging markets but outperformed in non-US developed markets.

US Stocks
The broad US equity market posted positive returns for the quarter but underperformed both non-US developed and emerging markets.  Value underperformed growth indices in the US across all size ranges. Small caps in the US underperformed large caps.

Period Returns 
By 07/2017
Data Series
1 Mo  YTD  1 YR  3Yrs*  5 Yrs*  10 Yrs* 
Marketwide 1.89 10.99 16.14 10.52  14.79  7.83
Large Cap 1.98 11.44 15.95  10.58  14.85  7.84
Large Value 1.33 6.05 13.76 8.45   14.00  6.21
Large Growth 2.66 17.02 18.05  12.66  15.60  9.36
Small Cap 0.74 5.77  18.45  9.89  14.19  7.76
Small Value  0.63 1.18 19.21  9.50  13.76  6.94
Small Growth 0.85 10.91 17.76  10.22  14.58  8.49

International Developed Stocks
In US dollar terms, developed markets outperformed the US equity market but underperformed emerging market indices during the month. Looking at broad market indices, the value effect was positive across all size ranges in non-US developed markets. Small caps outperformed large caps in non-US developed markets.

Period Returns 
By 07/2017
Data Series
1 Mo  YTD  1 YR  3Yrs*  5 Yrs*  10 Yrs* 
Large Cap 2.98 16.18 17.27 2.27 8.51 1.44
Small Cap 3.52 19.51 18.49  6.16  12.03 3.34
Growth 2.46 18.42 12.29 3.80 8.71 2.16
Value 3.49 14.12 22.45 0.68 8.24 0.64

Emerging Markets Stocks
In US dollar terms, emerging markets indices outperformed both the US and developed markets outside the US.  Looking at broad market indices, the value effect was negative across emerging markets. Large caps outperformed small caps in emerging markets.

Period Returns 
By 07/2017
Data Series
1 Mo  YTD  1 YR  3Yrs*  5 Yrs*  10 Yrs* 
Large Cap
5.86 25.49 24.84 2.39  4.76  1.98
Small Cap 3.57 20.13 16.23 1.75 5.93 1.73
Growth 6.04 25.77 25.30 2.76  5.14 2.31
Value 5.29 19.66 21.48  (0.53) 2.44 1.51

Real Estate Investment Trusts (REITs)
Non-US real estate investment trusts outperformed US REITs.

Period Returns 
By 07/2017
Data Series
1 Mo  YTD  1 YR  3Yrs*  5 Yrs*  10 Yrs* 
Dow Jones U.S. Reit Index 0.92 2.29 (5.66) 8.30  8.79  6.39
S&P Developed Ex U.S. Reit Index 3.29 9.41 (2.39) 2.44  6.83 1.07

The Bloomberg Commodity Total Return Index returned 2.26% during July. The softs complex led the index higher, with coffee returning 10.9%, and sugar up 8.1%. Livestock was the worst-performing complex down 4.8%, with lean hogs declining 6.30% and live cattle falling 3.80%. Hard Red Wheat experienced a decline, losing 10.30%.

Fixed Income
Interest rates were mixed across the US fixed income market during July. The yield on the 5-year Treasury note decreased 5 basis points (bps) to 1.84%. The yield on the 10-year Treasury note decreased 1 bp to 2.30%. The 30-year Treasury bond yield increased 5 bps to finish at 2.89%. The yield on the 1-year Treasury bill fell 1 bp to 1.23%, and the 2-year Treasury note yield fell 4 bps to 1.34%. The yield on the 3-month bill increased 4 bps to 1.07%. The yield on the 6-month bill decreased 1 bp. In terms of total returns, short-term corporate bonds gained 0.37% and intermediate corporates gained 0.72%. Short-term municipal bonds gained 0.45%, while intermediate muni bonds returned 0.74%.

Period Returns 
By 07/2017
Data Series
1 Mo  YTD  1 YR  3Yrs*  5 Yrs*  10 Yrs* 
Barclays Municipal Bond Index 0.81 4.40 0.26 3.55 3.10 4.60
Barclays U.S. Aggregate Bond Index 0.43 2.71 (0.51) 2.71 2.02 4.44
Barclays U.S. Corporate High Yield Index 1.11 6.09 10.95 5.34 6.72 8.17
Barclays U.S. Government Bond Index 0.17 2.03 (2.40) 2.10 1.14 3.80
Barclays U.S. TIPS Index 0.45 1.30 (1.04) 0.77 (0.02) 4.09
BofA ML1-Year US Treas Note Index 0.13 0.43 0.54 0.45 0.38 1.17
BofA ML 3-Month US Treas Bill Index 0.09 0.39 0.54 0.26 0.19 0.55
Citi World Govt Bond Index 1-5 Years (hedged to US)  0.25 0.90  0.50  1.38  1.35  2.46

Feature article

How Moral is Your Portfolio? 

Socially responsible investing (SRI) originated in mid-century religious imperatives to shun “sin stocks” like alcohol, tobacco and gambling. Over the intervening years, the idea evolved to include women’s rights, workers’ rights, environmentalism and other issues of current social concern. Oil spills, nuclear accidents, polluted rivers and other highly visible indicators of corporate irresponsibility ignited a fuse under environmental activism. Global warming turned attention to coal and fossil fuels. In response to activist shareholders, the tent expanded to include corporate governance, so you’ll sometimes see the acronyms SRI and ESG (short for environmental, social and governance) used interchangeably. 
An eye-popping number of institutional level clients claim the mantle of socially responsible investing, accounting for a fifth of all assets under management. But in terms of dedicated funds, SRI remains a niche in the mutual fund world. According to Morningstar data, just 225 US equity funds managed $182 billion in SRI assets in 2016, less than 5% of the $6.4 trillion invested in all domestic equity funds. But with Al Gore touting the sustainable investing Generation fund, tech and food companies clamoring for higher moral ground, and millennials leaning toward “values-based” investing, it’s clear that SRI is a trend worth watching. 
The SRI Conundrum
If you’re considering SRI or ESG funds, here are a few issues to consider.  
SRI funds can run counter to passive investing and indexing principles. Some funds exclude certain companies, sectors within an industry, or entire industries. A fund may engage in trading as companies fall out of favor or work their way to SRI approval (Nike is an example of an off-then-back-on company). When SRI funds are not well diversified, they carry higher risk. 
Who’s doing the evaluating? SRI evaluation relies on positive and negative screening. A positive screen selects companies with socially responsible business policies and practices, while a negative screen excludes those considered harmful. These “in or out” screening styles leave a lot to be desired. Multinational corporations are typically involved in dozens of businesses, making thousands of daily choices that impact people and the environment. Good? Bad? A little of both? Negative screening might exclude all oil companies, while positive screening might include one or two. Should BP be out, and Exxon Mobil in? You may agree with Warren Buffet’s observation that “It’s ridiculous when people say one oil company is more ‘pure’ than another.”   
SRI and ESG lists are subjective. It’s reasonable to ask how firms like KLD Research and Analytics make decisions. Are they influenced by good corporate PR and marketing? Are evaluations done first-hand, or do they rely on third parties to visit factories and assembly plants? Do membership associations of socially responsible corporations gather fees from those they evaluate? 
Writing about KLD in 2007, Joe Nocera (NYT) asks how a small staff could possibly provide comprehensive assessments of 3,000 companies operating all over the world. “KLD’s co-founder, Peter Kinder, said that the staff almost never goes abroad to do on-site inspections, but relies on media reports, blogs, activist organizations and the companies themselves. That hardly seems like enough.”
Personal values and social responsibility. We all have our own personal litmus tests, or think we do. In practice, our values are flexible and responsive to new information. For example, you may believe gambling is terrible and ruins lives, but would you invest in a gambling company with a good track record of job protection for low-income workers? You love fine wines and spirits, but would you invest in an international spirits conglomerate with a habit of killing jobs by purchasing and shutting down small producers? Perhaps you shun Walmart for its labor practices and for putting small grocers out of business, but do you applaud it for bringing organic produce to the masses?
Most of us make exceptions for irresponsible corporate behavior. Would you buy a Volkswagen despite the emissions cheating scandal? Do you have a bank account at Wells Fargo, even though it opened unsolicited accounts (and is in the news again today for unsolicited auto insurance)? Do you use an Apple computer or iPhone, despite the company’s alleged labor practices and the environmental footprint of discarded batteries and electronic products? Do you eat endangered fish? 
If you have issues with these companies, you might also have issues with the so-called good companies on the MSCI KLD 400 Social ETF. The list includes Verizon (accused of violating consumer privacy and selling information), Coca-Cola (arguably one of the greatest worldwide contributors to diabetes and obesity), Procter and Gamble (accused of environmental infractions including widespread deforestation related to palm oil sourcing, and groundwater pollution), and Tesla (accused of sourcing low carbon materials from supply chains linked to child labor, and mistreatment of indigenous communities in South America). KLD excludes the easy ones, perhaps, but these and other companies on the list are no angels.
Again, determining who’s good and bad depends on your viewpoint. A 2015 EcoWatch report claims that “Nearly half (45%) of the world’s largest companies are obstructing climate change legislation. And those that aren’t actively obstructing climate policy are members of trade associations that do.” Would you disinvest from those companies on principle? And relatively speaking, how bad are the other 55%? 
Eliminating Vice Can Hurt Returns
We would love it if all corporations were rewarded with higher returns for doing good. But corporations are in the business of creating value for shareholders, not to express values that are pleasing to a subset of investors. (That said, woe to the corporation that doesn’t have HR-approved “Our Values” and “Our Mission” statements.) 
In a 2007 article in The Atlantic, Henry Blodget shares the example of Philip Morris, the single best-performing stock in the S&P index for the 46 years through 2003: “Thanks to the miracle of compounding, if you had invested $1000 in the S&P 500 in 1957, you would have ended up with $124,000 in 2003. If you had invested in every stock in the S&P 500 but Philip Morris, you would have ended up with about 5% less. If you had invested in just Philip Morris, you would have ended up with $4.6 million.” 
If you value high earnings on your investments, eliminating all harmful companies from your portfolio probably isn’t the way to go.  
The Big Picture
SRI is complex because it involves moral decision-making. But that doesn’t change the way markets work. Expectations of future returns are built into current prices. Market efficiency is to be expected. If there is universal agreement that socially responsible investing improves stock prices, that expectation is already built into the stock price of a socially responsible company. Meir Statman of Santa Clara University suggests that over the long term, SRI will produce superior returns only when enough investors “consistently underestimate the benefits of being socially responsible or overestimate its costs.” 
By the same token, companies ranked lower on SRI or ESG lists (or not on the list at all) may generate better future returns. Companies dinged by a bad report can improve policies and processes, exit a line of business, or cease sales of a certain product to maximize expected future profit. When investors flee a company or market sector, beaten-down returns can be an investment opportunity.  
How have SRI investment returns held up recently compared to the S&P 500? We sorted the SRI large cap fund universe for those with at least a 3-year return history. The average return was 9.1%, with an average expense ratio of 0.80%. The MSCI KLD 400 Social Index ETF referenced earlier in this article performed better than average, returning 9.69%. But both numbers are significantly worse than the S&P 500, which had a trailing 3-year average return of 10.87%. 
Behaving socially, responsibly and profitably is challenging for any company. Consumers can be harsh judges, moving their money out of banks, refusing to buy certain cars or products, and damaging retailers with boycotts. Regulatory agencies reinforce good behavior too, though their influence has been diminished under the current Administration. And shareholders want good returns. 
SRI deserves more than our blind trust. We all would like to see the “good companies” succeed and make money too, but that may be wishful thinking. If you’re interested in SRI, take time to evaluate the different funds and the screens used to move companies on and off lists. Are your ethical concerns addressed? Another option is to choose a simpler approach suggested by Professor Statman: “… invest in very low-cost index funds and then support the charities or causes you believe in with a direct donation.” 
I believe that doing good work in support of one’s values is more important than ever. As for investing, risk management, diversification, proper asset allocation and a low cost structure remain the primary drivers of a sound portfolio. If you’re interested in integrating social or ethical investing into your portfolio, be aware of the inherent limitations and contradictions.


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