One topic we have assiduously avoided here at Abnormal Returns is the topic of socially responsible investing or SRI. However a piece by Diya Gullapalli in the Wall Street Journal highlights a number of important issues for portfolio management.

Our goal here is not to tear down those who invest in or manage portfolios based on the (varying) principles of SRI. Everyone should feel free to invest in whatever manner their conscience directs them. However, socially responsible investors should also be aware that their strategy is inherently compromised.

The main thrust of the Gullapalli article is that certain SRI mutual funds are now re-examining their strategies based on the recent poor relative performance. This might come as a shock to some socially responsible investors because some backers of this approach often claim that by screening out so-called “socially irresponsible” companies they can achieve higher returns.

A brief detour into finance theory should help dispel this notion. Over certain time periods a SRI fund can outperform the overall stock market. For example, many SRI equity funds are overweighted in large cap growth stocks which will drive the fund’s relative performance. The problem is not necessarily one of style, rather two important influences challenge the notion that SRI is somehow a superior strategy.

Let’s think for a second about what it would take for a SRI fund to outperform the market on a regular basis. There are two crucial assumptions. The first is that the stocks screened out on a SRI basis have inherently lower returns. That is not out of the realm of possibility. Second, one must also argue that there is no demand-effect on the remaining stocks. That is, the artificial demand from SRI funds will not drive up the price of these remaining stocks to levels below that of the market or the already screened-out stocks.

One could easily argue that the screened-out stocks should in fact have higher expected returns. Based upon these outward characteristics these companies are likely to be priced at lower multiples than warranted by their business risk. If there is a “value premium” these stocks are likely to be value stocks. Therefore excluding them is likely to harm portfolio performance.

We doubt that the SRI community is large enough to significantly distort the relative valuations of screened-in and screened-out stocks. But the characteristics that attract the SRI crowd will also be attractive to other investors as well. Who doesn’t want to get the warm and fuzzy feeling from owning stock in a company that on the face of it is doing all the right things in regards to the industry in which they operate and the way they treat their employees? Investors are in all likelihood making the mistake that if they invest in a “good company” they are in fact getting a “good stock.” That is at best a hopeful statement.

The bottom line is that socially responsible investing is an investment strategy. (We should also note there are a number of different approaches to SRI, we are of course talking in general about the subject.) By investing in a way that differs from the market portfolio investors are taking on the risk (and potential reward) of having returns that differ markedly from the market. Another investment approach in the news, fundamental indexation, is an interesting one to contrast with SRI.

Fundamental indexation, like SRI, is at its heart an investment strategy. Calling it “indexing” is a bit of a misnomer. Fundamental indexing varies the weight of stocks in the portfolio (versus the market index) based upon certain fundamental measures, like earnings, book value, or dividend yield. This approach overweights certain stocks versus others. By doing so it will generate returns that differ from the market index. In contrast with SRI there is good reason to believe that this approach, which is value-oriented, will over the long run outperform the overall market.

Let us reiterate that none of what we have written should dissuade any one from investing in a SRI mutual fund, of whatever stripe, if that is what your conscience dictates. We are all for consumer choice in all manner of financial products (while keeping an eye on expenses). However one should make an investment decision with your eyes open and with a healthy respect for the compromises that are inherent in a SRI approach.

This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

Please see disclosures here.

Please see the Terms & Conditions page for a full disclaimer.