Avoidance screening vs. Best-in-class investing

By Michael Kramer
This article first appeared in the April 2008 edition of the Natural Investing newsletter

As you may know, our company, Natural Investments LLC, constantly monitors the field of socially responsible mutual funds and evaluates them with our NI Social RatingSM. This puts us square in middle of an ongoing dialogue among SRI professionals about different approaches to being “socially responsible”. Two of the main schools of thought are “avoidance screening” and “best-in-class”. The first seeks to avoid entire industries that are viewed as harmful, while the second includes companies in problematic industries but invests only in the companies that are judged to be the best in their sector for environmental and social performance. The appropriate approach, it seems, depends on one’s personal and societal goals.

Kinder, Lydenberg & Domini (KLD) is a leading corporate social research firm that has created numerous SRI indices that represent both approaches. Their flagship Domini 400 Social Index practices avoidance screening. But their newer products, such as the KLD Global Sustainability Index, include the industries’ best companies in most sectors rather than exclude them. Since indices typically put more emphasis on larger companies, the results can bring about odd situations where, for example, Royal Dutch Shell is the second largest holding of the Global Sustainability Index.

Many investors think that an index should not label itself as “sustainable” when it contains oil companies and others such as automotive, mining, or chemical companies. KLD and the funds which license its indices say that this best-in-class approach results in an index that more accurately resembles and tracks the performance of conventional indexes and funds. They argue that it has been difficult for avoidance-based SRI products that exclude fossil fuel companies and defense contractors to compensate for the impressive gains in those sectors. A best-in-class approach, therefore, not only provides exposure to those profitable sectors, but it establishes a more fully diversified sector allocation.

Beyond the financial argument, proponents of best-of-class strategies argue that it can be more effective than avoidance screening at advancing sustainability. In every sector there are leaders and laggards in environmental, social, and governance performance, even in sectors that many regard as deeply flawed, like mining or oil extraction. If companies in those industries are completely shunned by avoidance screening, they will have no incentive to improve their behavior. But if they know that by improving they could qualify for best-in-sector investors, they may feel that this provides a financial incentive to address their problem areas.

The social performance of the leaders gets them positive attention and a larger pool of investors, while the losers have to improve their performance in order to avoid being punished for having a bad reputation. Many of the codes, monitoring, and enforcement policies and practices on issues such as child labor and sweatshop working conditions and in pollution-causing industries emerged from these market forces.

In addition, many mutual funds that use the best-in-class approach are becoming increasingly active as shareholder activists, pushing companies forward by opening dialogue with corporate leaders and introducing proposals onto the proxy ballots for voting on by shareholders.  If you do not own individual company stocks, but want to be part of this important aspect of natural investing, then holding one or mutual funds that engage companies in this way is your best bet.

But many investors can’t bring themselves to hold some of these offensive companies. Ethical investors generally have the impression that they’re creating positive change by avoiding problem sectors. The theory is that if those companies know they are avoided because of their environmental or social performance, this might exert an influence on them to find more sustainable ways to meet society’s needs.

However, it’s not clear if this actually works, because even if we avoid certain industries, there are always other investors available to take our place. More fundamentally, though, it’s impossible to invest in a perfectly sustainable fund or index, for no matter how carefully it picks stocks, we are not yet able as a human civilization to produce and distribute products without fossil fuels. This might change, but it hasn’t yet occurred. Every industry, every company, and most people in industrial societies live in some way dependent on fossil fuels, on automotive and often ship transportation (with internal combustion engines), and live in dwellings where the paint and the plastic and half of everything else came from the chemical industry. As this is deeply unsustainable, the choice we all face as investors is whether we believe sustainability is best advanced by constructing portfolios that avoid the most unsustainable sectors (even though we continue to consume their products), or by investing in companies that are at the forefront of sustainability in nearly every industry, and hoping to create enough competitive distance that the laggards are forced to become more sustainable by the pressure of markets.

There is a place for both strategies. Some industries don’t belong in any SRI portfolio – tobacco seems obvious, as do other products such as weapons that are designed to harm or kill. But because the world isn’t going to stop using oil right away, anything we can do to move oil companies in a more sustainable direction is important. There need to be ways to reward the companies that are making the most effort to find their way along the green path.

Creating better awareness among investors of who the leaders are will hopefully encourage the laggards. Raising the bottom is just as important as rewarding those at the top. So while there are numerous gray areas in this field and no one-size-fits-all solutions, our actions can help encourage corporate leaders will “see the light” and decide that their company’s survival, and our civilization’s, depends on their willingness to change.

 

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Michael Kramer

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