WealthManagement Magazine

Why the CW on SRI Is Wrong

Ever since socially responsible investing began as a protest against the Vietnam War and as a lever to force U.S. multinationals to stop doing business in South Africa the concept has been viewed with suspicion in most parts of the investment industry. For financial advisors, the conventional wisdom has been that SRI clients were long on political and ethical commitment, but short on investing smarts.

Ever since socially responsible investing began — as a protest against the Vietnam War and as a lever to force U.S. multinationals to stop doing business in South Africa — the concept has been viewed with suspicion in most parts of the investment industry. For financial advisors, the conventional wisdom has been that SRI clients were long on political and ethical commitment, but short on investing smarts. Even worse, they tended not to bring in big accounts. And, by using nonfinancial criteria to pick stocks, these investors were doomed to underperform — as would any broker foolish enough to take these clients on.

Like all conventional wisdom, the CW on SRI has some elements of truth — and it is also wildly out of date. Yes, SRI remains a tiny slice of the equities business. And, yes, few he-man wirehouse brokers have snagged a trip to Bermuda for plugging SRI funds.

But SRI is gaining momentum as a financial advisory specialty and, with a growing range of SRI products and a cadre of top-flight managers in the field, it's getting harder to prove that there is a performance penalty. “I think the performance argument is weakening,” says Greg Carlson, an SRI fund analyst with Morningstar. “We have enough data, in particular for large-cap SRI funds, to show that they can perform as well as their peers.” (see table, page 99). Between 2001 and 2003 (the last period for which the analysis was performed by the Social Investing Forum, an SRI booster) more than 40 percent of SRI funds had Morningstar's top four- and five-star ratings; only 32 percent of all funds fared so well.

More importantly, there is a growing perception among some savvy investors — including major institutions and high-net-worth individuals — that SRI screening techniques provide an additional layer of scrutiny that is particularly useful in a post-Enron, post-WorldCom environment. “Now, people are beginning to see that how companies deal with social and environmental issues is a proxy for how they manage overall and an indication of how well they will do overall,” says Eric Leenson, CEO of Progressive Asset Management, a network of 50 SRI financial advisors affiliated with broker/dealer Financial West Group.

The Turning Worm

In other words, the picture of SRI may be reversing: Instead of avoiding socially or environmentally screened portfolios because of the presumed performance penalty that results from narrowing the field of possible investments, institutions (and a growing number of advisors) are choosing SRI managers precisely because of the way they define the universe of potential picks.

“We're now seeing institutions with hundreds of billions in assets looking at SRI screening,” says Timothy Smith, the longtime executive director of the pioneering SRI group, the Interfaith Center on Corporate Responsibility, and now president of SRI for Walden Asset Management in Boston. “They start at a very different place than the tree huggers. They are fiduciaries and they are asking questions about environmental and workplace issues for fiduciary reasons.”

For similar reasons, the number of individual investors and advisors who are attracted to SRI is expanding. “Even advisors who are not front-and-center in the SRI business are putting clients into these products based on performance,” says Craig Cloyed, president of Calvert Distributors, who says the firm's sales of equity funds have jumped 50 percent in the past year.

“With events like Enron, the public really has focused its attention on corporate behavior,” says John Wilson, director of SRI for Christian Brothers Investment Services, where assets under management have jumped from $1.5 billion to $4 billion in the past eight years. “A lot of the success we've had recently has had to do with the changing relationships between the public and corporations since the recession and the scandals.”

All this is pushing SRI toward the mainstream. “I think the market is moving in our direction,” says Cliff Feigenbaum, publisher of the Green Money newsletter, which has covered SRI for 15 years. “I used to be on the fringe.”

Good Business Is Good Business

Reps and advisors who have carved out an SRI specialty are seeing more business and more advisors are becoming converts. There isn't a clear accounting of the number of advisors who devote all or part of their practice to SRI, but one indication of the growth is the number of advisors who list with the Social Investing Forum. The ranks have jumped from about 280 to 480 in the past two years.

And, because of rising demand — including from a noticeable cohort of well-heeled boomers who are looking to make money and make a point — SRI is even gaining traction in the wirehouses. “I get calls at least once every two weeks from a big wirehouse broker who says, ‘Hey, I have a client who is interested in social investing, what can you tell me?’” says Ken Nostro, director of b/d distribution for Domini Social Investments, a new position aimed at raising Domini's profile with reps. The company has also added its first load fund, an A-share version of its large-cap equity fund.

One recent recruit to the SRI ranks is David Jarmusz, who owns Cherry Street Family Offices in Winnetka, Ill., with his wife, Molly. “We're the last people you would expect to find in this business,” says Jarmusz, 40. “We're business people, we are not environmentalists. We are pro-business.” Before going into the financial advisory industry four years ago, Jarmusz worked for Ernst & Young and for a venture unit of Accenture, the consulting firm. Molly worked for Duff & Phelps, an investment bank. Their home base, on Chicago's ritzy North Shore, is certainly not on the Birkenstock belt. “Out here in blueblood land, we wind up spending a lot of time defending what we do,” says Jarmusz.

What convinced the Jarmuszes to look into SRI was a request by one of the five wealthy families that have placed a total of $70 million with Cherry Street. The client had recently sold the family business, a company that had won awards for its workplace practices. The family felt very strongly about building a new diversified portfolio by investing in companies that shared its values. Jarmusz began researching SRI managers and selected Trillium Asset Management and Boston Common Asset Management, among others. He also signed up with First Affirmative Financial Network, an SRI advisory firm that runs funds and managed money and provides custom screening tools for 130 reps.

That was two years ago. Pleased with the results of his SRI managers and turned on by the enthusiasm of their client, the couple decided to shift the entire practice to social investing and to set up as a registered investment advisor. “We saw that SRI is just good business,” says Jim. “You're weeding out all those problem companies that can blow up.” He notified the other four families that as of January 2005, Cherry Street would focus exclusively on SRI. They all stayed on.

Sticky Customers

Jarmusz echoes what other SRI advisors say about their customers: “These are the greatest clients,” he says. While SRI investors have varying agendas — some are only concerned with the environment, some are anti-abortion, some are most concerned with workplace issues — they also have common traits that make them good customers. They tend to be highly educated. They are likely to be involved in community affairs. They are volunteers. They are travelers. They follow world events. Mostly (60 percent), they are women. And, because they have a long-term goal to use their investments to effect changes that will take years to accomplish, they are patient.

“One thing I have found about SRI investors — they are more inclined to be hands-on with their investments,” says Frank Buress of Buress Financial Services in Green Bay, Wis., “And, by golly, they are loyal. We have lost very few clients.”

Indeed, SRI clients were less inclined to cut and run when the markets went south in 2000. “During the downturn, when people were pulling money out of other mutual funds, assets were increasing in SRI funds,” notes Green Money Journal's Feigenbaum. Indeed, between 2001 and 2003, assets of SRI-screened managed money and mutual funds rose by 7 percent.

Another thing that Buress has noticed since he began concentrating on SRI, is that it very quickly becomes a strong referral business. A former organizer for the California Teachers' Assn., Buress moved to Green Bay after meeting a woman from the area at a National Educators Association convention. They married and started working together at A.G. Edwards (she has since gone back to union work and he has affiliated with Commonwealth Financial). Buress began to specialize in SRI because Green Bay is a union town and he had clients who wouldn't support companies with poor records on workplace issues. Other prospects were concerned about the environment. As he learned to accommodate their requests, word spread. “I don't do any marketing now,” he says. “It's all referrals.” And, he adds, his business grew 30 percent last year.

Just how mainstream SRI will ever become is a big question, even among the most dedicated practitioners. “Anecdotally, we see a very, very healthy interest and we also see a tremendous opportunity,” says Steven Schueth, president and chief marketing officer of First Affirmative. “But this is still a niche. It's not a fast-growth business, but it is very steady.”

The Wirehouse Question

One hurdle for the expansion of SRI is the lack of enthusiasm at the major wirehouses. “I don't think the brokerage houses have yet to see this as an interesting enough marketplace,” says Leenson of Progressive Asset Management, who began his financial career as a Merrill Lynch rep. “So, it's still a question of the individual broker seeing the opportunity.”

Yet a growing number of wirehouse reps are building their books with SRI. There are reps from Merrill, Smith Barney, A.G. Edwards and UBS on the Social Investing Forum list. A young Merrill broker, who asks that his name not be used, says that he gets reasonable support from his branch manager, but not much from the firm. Many of the top SRI products and managers are available to Merrill brokers, but some of the issues he would like to put clients into — like some small companies involved in alternative energy — are forbidden. “If they don't cover them, we can't sell them,” he notes.

Within the branch, he is becoming known as the go-to person for social investing, just as another rep is the expert on 529s. And, he says, he is finding a nice response among baby boomer clients, who have assets and real planning needs, but also have qualms about retiring on gains from Exxon-Mobil. “They can't believe they can have a socially-conscious stock broker,” he says.

For some reps, SRI is a competitive edge. “The way I position it is that most high-net-worth clients use more than one advisor,” says Nostro of Domini. “If you have the SRI specialty, you are not just another advisor.”

That's what motivated Martin (not his real name), a young broker who works for the branch of a major wirehouse near San Diego. “I'm not a bleeding heart kind of person, but I do have a concern for the environment,” he says. As happened with Jarmusz, a wealthy client prodded him to research SRI managers. “Our first concern was performance, but we saw that when it came down to risk-adjusted performance, the screening produced better results,” he says.

Over the past four years, the screened positions began taking over more of the accounts that he shares with a veteran rep in the office. While the specialty appeals to wealthy clients of all ages, including some who are long into their retirement years, Martin says his reputation for SRI savvy is bringing in younger clients, who are interested in environmentally friendly and fast-growing companies. “The companies that have a green mentality may be a little more forward thinking, a little more cutting edge,” he says.

Green and Growing

Perhaps the best news for the SRI business is that the universe of SRI funds and managers continues to grow, as does the variety of products. “You can show mutual funds that have proven performance. And you have enough different products that you can fill all the money-management boxes,” notes Michael Lent, partner and branch manager of Progressive Asset Management New York. Lent and his partner, Steve Fahrer, manage $300 million for wealthy individuals, endowments and nonprofits. They invest through PAM, the largest independent b/d focused on SRI and use the advisory services of the First Affirmative Financial Network.

In addition to specialists like First Affirmative and longtime SRI brands like Calvert, PaxWorld and Domini, such mainstream money managers as Smith Barney, Neuberger Berman and Morgan Stanley also run SRI funds. In the past year, Calvert has added three asset-allocation funds, which blend its SRI equity fund with its fixed-income and money-market products in three risk-adjusted formulas. It has also brought out small- and mid-cap value funds. Domini, which has begun selling advisor funds, is registering for a new European Social Fund. “This sector is attracting more and better managers, and the chances are it will continue to do so,” Carlson of Morningstar says. The sector even has inspired a handful of hedge funds, including the newly minted GAMCO SRI Partners, from Gabelli Asset Management, which has been involved in SRI since 1987.

The approaches to SRI have also multiplied. Early on, the approach was simplistic, known as negative screening: Managers would simply banish entire industries (usually the “sin” merchants — tobacco, arms and alcohol) from their portfolios. Environmental screens eliminated all extraction industries. “In the beginning, if you were interested in the environment, there were no companies to invest in,” recalls Progressive Asset Management's Leenson.

Best of Class

Today, SRI managers take a more nuanced approach. Rather than merely screening out bad actors, many managers and advisors are taking a “best of class” approach. This involves taking positions in companies that are responding to shareholder advocacy and working with investors on issues like climate change. So, for example, a manager can choose an electric utility that has some coal-fired generators — if it has good corporate governance, treats its workers well and is also working on coal gasification to reduce emissions and investing in renewable energy technologies, such as wind power.

The bonus for SRI advisors and clients is that the best-of-class approach also yields better returns. “You don't ignore big parts of the equity markets,” says Gary MacDonald of State Street Research, which sells a screened product. “From a fiduciary point of view, that's not prudent.”

And, working as shareholder advocates, SRI managers can help companies rehabilitate themselves, rather than banning them forever. Calvert Funds, for example, dropped Nike in 1998 because of its poor record on the sweatshop issue. In late August, Calvert announced that the sneaker maker, which has made exhaustive disclosure of its practices and has permitted independent verification of its claimed improvements, is now being recommended by Calvert researchers for inclusion in the Calvert Social Investment fund. “If we see a good trajectory, we really like that,” says Lily Donge, a social research analyst at the fund company.

The new flexibility is not without its critics. Paul Hawken, a successful entrepreneur and social activist, last year issued a scathing critique of SRI fund managers, charging them with letting some of the worst offenders on social, health and environmental issues slip through their screens. Hawken, who runs the Natural Capital Institute, a Marin County, Calif., think tank, said the term socially responsible has been interpreted so broadly that it has become virtually meaningless. He then announced plans to create his own SRI screening system.

Clearly, the best-of-class approach has its pitfalls. Enron, for example, made it through some SRI screens, including Domini's, because it was a relatively clean energy company (its core business was transporting natural gas) and it was a big player in developing wind power. And, ironically, other SRI funds admitted Enron because it passed such corporate-governance litmus tests as having an independent audit committee.

But, with increasing public scrutiny of corporate behavior and improved disclosure, SRI managers are less likely to get fooled again. And they are convinced that more investors will come around to their way of thinking. They point to the ranks of major corporations that, after prodding from shareholder activists, are now providing environmental and social-impact reports along with their financials. This disclosure sets up a process to reduce potential liabilities and positions the companies to pass through SRI screens. And that, could be a win-win situation, for investors and for the investing business.

WHAT PERFORMANCE PENALTY?
Top Socially Responsible Funds Over the Last Five Years.
Fund 1-Year 3-Year 5-Year 5-Year Category Average
Calvert Social Investment Equity 1 Large-Cap Growth 14.17% 11.49% 4.18% -6.98%
Amana Mutual Funds Trust Income Large-Cap Value 28.36 18.33 5.49 5.53
Pax World Growth Mid-Cap Growth 19.86 16.59 -2.01 -3.07
Maxim Ariel Midcap Value Mid-Cap Value 18.17 13.73 12.88 12.20
Citizens Small Cap Core Growth Small-Cap Growth 22.32 14.92 2.29 -0.15
Ariel Small-Cap Value 20.30 17.52 15.46 15.99
Neuberger Bergman Socially Resp Inv Large Blend 19.72 17.66 6.83 -0.83
Timothy Plan Small-Cap Value A Small Blend 8.38 12.64 6.76 11.57
Ariel Appreciation Fund Mid-Cap Blend 18.00 14.20 12.99 7.69
Source: Morningstar
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