Ethical Investment

Socially responsible investing has been in the news lately -- or maybe I'm just more sensitive to it because a colleague is working in this area.

NPR did a piece on whether you should own stock in a company you despise. Many finance professionals will tell you that socially responsible investing implies a lower return. This is because eliminating "sin" stocks from your portfolio reduces the set of companies you can choose from, thereby limiting the diversification you can achieve and making your portfolio inefficient. Last week the Wall Street Journal reported that Pax, a large socially responsible mutual fund family, is asking shareholders to allow them to eliminate the zero-tolerance policy toward alcohol and gambling stocks.

For Pax, the move comes after it had to sell a lucrative stake in Starbucks Corp. last year when the company set up a deal to launch a coffee liqueur with whiskey maker Jim Beam. The funds' 375,000 shares were valued at $23.4 million at the time, and had to be relinquished even though some SRI researchers estimate liquor-related sales contributed less than 1% to Starbucks's revenue.

Pax is employing what's known as a 'negative screen.' This method eliminates entire industries from the investment choice set, and will make it difficult to construct an efficient portfolio. Another approach to SRI is the best-of-sector approach where you rank firms based on their level of social responsibility and choose the highest ranked firms in each industry or sector. The Dow Jones Sustainability Index is based on this best-of-sector approach.

For an academic take on SRI see Lee, Darren David and Faff, Robert W., "The Corporate Sustainability Discount Puzzle" (July 2006). Available at SSRN: http://ssrn.com/abstract=921501