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Socially Responsible Investments: How Do They Stack Up?

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So socially responsible investment sounds like a great way to save the world, but that's not everyone's goal. You're an investor, not a philanthropist. So, you might ask how so-called "responsible" stocks or funds compare to the broader market. Let's take a look.

The idea motivating the dramatic growth of socially responsible investing, or SRI, is that businesses that benefit society in addition to building wealth for shareholders will outperform businesses that do not improve society in the long run. Socially responsible companies create value for all stakeholders, not just shareholders, and the belief is that this additional value will be reflected in an increasing share price. By producing satisfied employees and enriching the city the company operates in through community engagement programs, socially responsible companies aspire to generate value that exceeds the bottom line. As more and more investors value companies that make the world a better place, these accountable companies will also generate positive returns for shareholders. In contrast, "less-responsible" companies can endure costly environmental or ethical regulations, negative media attention, expensive lawsuits, and investors avoiding their stock, all of which will hurt their value.

The idea that SRI companies also perform better financially sounds great, but is it true? Luckily for investors, many studies have compared the performance of socially responsible assets with ordinary investments. For example, the FTSE KLD 400, an index of socially responsible stocks created in 1990, generated annual returns of 9.51% (through 2009), compared with the 8.66% return achieved by the S&P 500 over the same period. Countless other studies have demonstrated that SRI mutual funds are competitive with their non-SRI peers (many of these studies can be accessed here). Socially responsible funds performed spectacularly even during times of economic turmoil: Large-cap SRI mutual funds outperformed the S&P 500 by 6% in 2009. The only major concern is that some SRI funds have higher fees associated with the additional costs of SRI screening.

Success stories are plentiful. After noticing that the stocks of publicly traded companies on Fortune's list of the "100 Best Companies to Work For" perform exceptionally well, Jerome Dodson, the founder of Parnassus Investments, created the Parnassus Workplace Fund (PARWX) in 2005 to invest exclusively in companies that treat their employees well. Here, his screen consisted of selected companies with exceptional workplace environments, while other screens could include factors like management diversity, environmental issues, or philanthropic activity. How did his experiment perform? The fund consistently outperformed the S&P 500 since its inception, and was US News' top-ranked fund in 2010.

Similarly, a 1995 study at Vanderbilt University (link opens PDF) compared two hypothetical portfolios, one consisting of "low pollution'' corporations while the other included "high pollution" corporations. Both portfolios were exposed to the same industries. Several variables determined which portfolio a company fit into, including the company's number of environmental litigation proceedings, Superfund sites, noncompliance penalties, and environmental spills. The authors concluded that the low-pollution portfolio performed better than the high-pollution group in 80% of comparisons. This result could be attributed to the low-pollution companies' superior management of raw materials and energy resources, or the high-pollution companies' environmental penalties or other costs associated with inefficient resource management. This study begins to substantiate the interesting notion that the improved efficiency of more environmentally friendly companies might produce a healthier bottom line as well.

The recent surge in popularity of socially responsible investment funds is a testament to the growing legitimacy of the movement. Unfortunately, it often takes an environmental catastrophe to pique investors' interest in socially responsible investing; in 2010, many investors scrambled to ensure their portfolio did not include BP (NYSE: BP  ) after the Deepwater Horizon oil spill. Still, the emerging commitment to socially responsible investing strategies by state pension funds, university endowments, and foundations (entities required by law to seek maximum returns) demonstrates that socially responsible investment strategies do not impede profitability.

One boon to the performance of socially responsible companies and mutual funds is less exposure to risk. Companies in controversial industries like tobacco, gambling, and oil face the added risks of further regulation, legal problems, and negative media attention. Socially responsible businesses are less likely to encounter regulatory penalties or harmful portrayals in the media, and this mitigated risk will ideally be passed along to investors through higher returns.

Not all companies, or even industries, that fit the socially responsible investment criteria will succeed. Alternative energy, a sector frequently associated with the SRI movement for its positive environmental potential, suffered greatly during the recession -- and has yet to fully rebound. While most alternative energy stocks meet SRI requirements, such companies do not necessarily make sound investments. Just like the broader market, some companies (and industries) are riskier than others ,and not all will succeed. You still need to conduct or obtain the appropriate financial and industry analysis to select companies that will give positive returns, regardless of whether the companies meet socially responsible investment standards.

None of this evidence categorically proves that all socially responsible investments are financially superior to other investments. But it does show that SRI assets are certainly competitive with non-SRI assets, and that the common belief that SRI strategies limit financial returns is largely misguided. So, if you want to boost returns while investing in companies that make the world a better place, why not pick out a socially responsible investment strategy that is right for you?

For another take, check out this article from Morningstar.

To learn more, click one of the links below:

Fool contributor Charlie Kannel owns none of the companies mentioned above. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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