Socially responsible investing: balancing financial needs with a concern for others.

Conventional wisdom has long held that stock market investors care only about profits. This attitude began to change in the late 1960s when socially conscious investors banded together to promote the stocks of certain companies. These investors avoided businesses that polluted, discriminated or exploited the third world or had conflicts of interest at the board level. However, they never gained enough momentum to have any significant impact. In 2003 socially responsible investors again are on the rise, and activists and profit-oriented investors alike evaluate a company's social conscience before investing. The reason is as plain as the Enron on your face--unethical companies drain shareholder value. For CPA financial planners who want to introduce socially responsible investing to their clients, this article provides a look at the foundations on which this investment philosophy is built.

MAKING THE RIGHT CHOICES

Socially conscious investors use four major strategies in deciding to employ their investment capital in a socially responsible manner:

* Screening for positive and negative issues.

* Shareholder advocacy.

* Community investing.

* Social venture capital.

Screening. Research services track and sell information on companies' socially responsible characteristics just as they do for financial data. CPAs can use this research to screen companies to make sure they don't produce objectionable products such as tobacco, alcohol or weapons. CPAs similarly can look for positive qualities such as equal opportunity employment and a lack of discrimination. CPAs should use these social screens after they have looked for stocks with the client's desired financial characteristics, such as a low price-to-book ratio or a high percentage of revenue growth.

Shareholder advocacy. Proponents frequently communicate the need for change in a company's policies or corporate governance by way of shareholder resolutions and verbal and written campaigns. For example, ExxonMobil investors voted their consciences and pocketbooks at the company's 2002 annual meeting. The case study on page 55 describes the details of this groundbreaking action. For a list of some shareholder resolutions that confronted other corporations last year, see exhibit 1, at right.

Community investing. A more direct way for clients to create social change is to invest in both the debt and equity of entities that work to bring about such change. Most community investing involves lending to inner city businesses, depositing money in banks that lend in under-developed neighborhoods or investing in mutual funds that engage in these activities. The Louisville Community Development Bank, for example, has lent money to local day-care centers, freeing more than 1,000 mothers to fill jobs in the area.

Social venture capital. Investors with a social focus can also find opportunities to buy into new or growing companies Detore they sell shares to the public. Many companies that produce socially responsible products are seeking investment capital, giving clients a chance to get into these ventures on the ground floor.

CPAs will find that screening is by far the most common selection strategy, but the other three techniques are gaining favor. Financial advisers typically focus on the first two because bad social policy and inadequate corporate governance have the most immediate effect on investments in stocks, bonds and mutual funds.

WHAT INVESTORS WANT

"A socially concerned investor cares about a company's record on social issues and about the credibility of the marketplace,"says Tim Smith, president of the Social Investment Forum and vice-president of Walden Asset Management in Boston. "Investors need to know there are rules for corporate governance and for social and environmental issues and that companies follow them." Walden Asset Management is a $1.2 billion subsidiary of U.S. Trust Co. and invests solely in socially responsible companies. The Social Investment Forum's 500 members consist of individual investment practitioners and institutions, which include financial advisers, analysts, portfolio managers, banks, mutual funds, foundations and community development, research and educational organizations

When Georgette Frazer started investing 25 years ago, she says she naturally followed a socially responsible strategy. As a CPA/PFS, CFP with Lifetime Financial Services LLC in Marshfield, Wisconsin, Frazer continues the practice today. She highlights the changes in the industry using the University of Wisconsin's retirement system as an example. Some 20 years ago students protested, saying the university should put its money into companies that supported positive social issues. Apartheid was a leading issue of the day. The trustees resisted, saying that to avoid certain companies might impair performance and they had a fiduciary duty to seek a high return. "Now they believe social investing is a requirement of their fiduciary duty," Frazer says.

Frazer is one of a small number of financial advisers who publicly claim to provide advice in this area. Many use the First Affirmative Financial Network, an independent registered investment adviser, in Colorado Springs, for fee-based asset management. FAFN offers separate account and mutual funds programs that meet socially responsible goals to more than 200 financial advisers.

Developments in socially responsible investing have helped ease the fears of investors such as pension plan sponsors and university, trustees. At one time, large institutions worried that this investment philosophy would hurt performance. But several academic studies have laid those concerns to rest. From 1990 to 1998 the Domini 400 Social Index--a benchmark that measures the impact of social screening on financial performance--returned 18.54% vs. 16.95% for the S&P 500. An article in the May-June 2000 Financial Analysts Journal, took a comprehensive look at the risk-and-return characteristics of socially responsible mutual funds. Not only did the screened funds do better, they did so at a modest risk premium--14.19% standard deviation vs. 13.23% for the S&P 500 (higher standard deviation means lower risk).

Even early converts couldn't fully commit to investing solely according to a client's values. "When I started my business 15 years ago, there weren't that many resources available to guide me," says Frazer. "Those that were available focused more on social responsibility than on the financial returns. Now the whole situation is different. Today these financial products perform just as well or better than their counterparts." For a list of current resources on socially responsible investing, see exhibit 2, below.

"I LIKE THAT"

Bob Dreizler, CLU, ChFC, started an active tax practice in 1975 in Sacramento, California, that evolved to include financial advice five years later. "I started hearing about socially responsible mutual funds in the early 1980s," says Dreizler. "I watched with skepticism because I was leery about how well they could do."

By 1988 Dreizler had fully committed himself to being an expert on this new way of investing. He presented the opportunities to his existing tax and financial planning clients, and they responded positively. "When I told people about the social screens, about avoiding polluters and finding companies with diverse boards of directors that balanced gender and race--all while achieving good performance returns--most clients said `Yes, I like that;'" says Dreizler.

Other research confirms that Wall Street rewards socially responsible companies. The Social Investment Forum, a nonprofit organization that provides information on socially responsible investing, gave its 2001 Moskowitz prize to a report titled "Do Corporate Global Environmental Standards Create or Destroy Market Value?" The report's authors found that companies that adhered to strict standards created greater market value. They looked at 89 U.S. companies in manufacturing or extractive industries that maintained production facilities with a large potential to pollute. Each company chose which environmental standard it would apply. The results may surprise some CPAs. First, nearly 60% of the companies adhered to the same high standard company-wide in every country where they did business, compared with the less than 30% that used the standards of the developing countries where they were located. Second, companies that chose the higher road each commanded approximately $10.4 billion higher market capitalization than those using local standards.

THE IMPORTANCE OF TRUST

CPAs recognize the need for high ethical standards is even more critical today. In a smokestack economy, company assets remained even if management committed fraud in reporting financial numbers. The board paid the fine, changed management personnel and went back to creating value from the hard assets. In the information economy, companies create value from intangible assets. Thus, when trust is gone, the other intangibles disappear. Once vendors won't extend credit, employees fail to see a bright future and investors abandon the company's stock, there's nothing left to trade on. The loss is catastrophic and permanent for those shareholders that hang on until the end.

Far more financial advisers pay attention to corporate governance issues today. James M. Luffman, CPA/PFS of Chas Smith & Associates in Lakeland, Florida, says initially his firm wouldn't buy tobacco stocks for client portfolios but that was the extent of its advice on socially responsible companies. Today, however, advisers at the 10-year old firm, which manages $300 million in assets, take a dim view of companies subject to an SEC inquiry or where the CEO has quit. "We've definitely included corporate governance issues in our sell strategy," says Luffman. "Before, we would have reviewed our investment decisions when those kinds of problems occurred, but we take a much harder look at it today."

MARKETING A UNIQUE NICHE

Both Frazer and Dreizler faced challenges in incorporating socially responsible investing into their traditional practices. Frazer reports that 60% of her clients--most referred by current clients--still seek the firm's more traditional investment advice. Dreizler used to give clients the presentation on socially responsible investing based on how they dressed or from what source they came to him. "Sometimes new clients said they came to me for socially responsible advice," he says. "But with my tax clients I never talked about social issues."

Both advisers find their specialty provides a unique marketing niche. Of the clients at Frazer's firm employing a socially responsible strategy, more than two-thirds sought out its services. Potential clients find Frazer through her firm's affiliation with the FAFN, through the booth it sets up at the local renewable energy fair or by attending one of the firm's public seminars. Dreizler mentions his specialty in a yellow-pages ad, but interested clients more often find him through his ads in an alternative monthly newspaper in Sacramento and at the local natural food co-op.

Steve Schueth, spokesperson for the Social Investment Forum and president of FAFN, reports that new advisers who become members say they'd been searching for help with socially responsible investing for some time. "Most just don't have the tools" says Schueth.

For CPAs who may want to introduce their clients to the socially responsible approach to investing, FAFN provides its members with access to a full range of socially responsible mutual funds and separate account programs. In the latter case asset allocation is driven by answers on a sophisticated questionnaire that assesses clients' risk-and-return needs and elicits the details of the personal values they wish their investments to express. FAFN then manages the assets and handles all back-office services.

A WEALTH OF CHOICES

Over the last 20 years the industry has grown from a handful of funds and a few asset managers to encompass enough choices in all asset classes for CPAs to construct a properly diversified portfolio. But it still has a way to go. "We lack an international and short-term bond fund,' says Frazer. "And there are no socially responsible fiduciary standards for insurance companies to allow us to choose insurance products to match the client's values."

She says CPAs will find the process of discovering the values clients want to apply to responsible investing a lot like the estate planning process. Frazer determines the client's risk-and-reward preferences before exploring his or her life goals and values. Then she constructs the investment program to meet both.

Frazer is sometimes surprised at the reaction clients have to responsible investing. She tells the story of a couple--a health care worker and a police officer--who wanted to invest in mutual funds. She prepared a financial plan that presented them with two investment options that had similar performance profiles. One fund didn't screen for social issues; the other performed two negative screens for alcohol and tobacco. "The police officer looked at the choices and said `These are two things that make my life miserable'" reports Frazer. "They decided on the screened fund."

STOCKS VS. MUTUAL FUNDS

CPAs will find that the choice between a mutual fund program and a separately managed account takes on a new dimension with social investing. When buying individual stocks, clients rate customized screens on how they reflect their unique requirements. "Mutual funds do their best work by broadly screening and highlighting the best and the worst of the group," explains Dreizler. "The advantage of owning individual stocks is that I can be very specific in the screens I select." This means CPAs can help clients purchase--or avoid--virtually any kind of investment. Mutual funds don't offer that kind of specificity.

Tobacco, environmental issues, human rights, employment equality, gambling, alcohol and weapons form the basis of almost all screening programs. Some less common issues are important but difficult to isolate. "If clients are interested in investing in companies with good animal rights practices, they'd be ill-served by buying mutual funds," says Dreizler. For a look at some of the screens investment managers apply in selecting investments, see exhibit 3, above.

Energy companies fall into a gray area. Everybody uses natural resources, so they're tough to exclude. "One couple didn't want to buy Exxon because of the Valdez accident so they wanted to exclude all oil companies from their portfolio. We convinced them they needed to own that sector--even it they preferred to avoid Exxon," says Luffman. "Not owning oil companies is a conflict for clients who own cars. Cars use gas, and oil companies produce that gas."

CLIENTS FIRST

Now that the market supports diversified investing and chalks up good performance numbers, Frazer expects to see more CPAs offering clients the opportunity to pursue socially responsible investing. "Lots of us got into the CPA profession partly because of the ethics. Integrity was emphasized even in school. Plus we've got the drive to do the work of crunching the numbers," she says. "All this matches our desire to fulfill our fiduciary roles in putting the client's goals first." The checklist in exhibit 4, at left, lists some of the steps CPAs can take to incorporate socially responsible investment strategies into their practices.

EXECUTIVE SUMMARY

* AS CONCERN FOR THE ENVIRONMENT, SOCIAL ISSUES and corporate governance increases, CPAs may find more interest among their clients in investment strategies and mutual funds that emphasize social responsibility.

* SOCIALLY CONSCIOUS INVESTORS MAKE DECISIONS by screening for positive and negative issues, shareholder advocacy, community investing and providing social venture capital. Screening is usually the first step to make sure companies don't produce objectionable products or engage in practices such as discrimination or environmental pollution.

* AT ONE TIME THERE WAS CONCERN THAT SOCIALLY responsible investing would hurt performance. But several studies laid those concerns to rest. From 1990 to 1998, the Domini 400 Social Index returned 18.54% vs. 16.95% for the S&P 500. Another study found companies that adhered to strict environmental standards created greater market value.

* EVEN FINANCIAL ADVISERS WHO DON'T SCREEN for social issues are concerned today about corporate governance. Many prefer to avoid companies that are the subject of an SEC inquiry or where there has been a change in senior management. Corporate scandals erode shareholder value, a commodity that's difficult to restore.

* INVESTORS WITH MORE CUSTOMIZED SOCIAL screens will find buying individual stocks, as opposed to mutual funds, makes it easier to satisfy their concerns. Mutual funds do their best work in broad screening. For example, it would be difficult to use mutual funds to support companies with good animal rights practices.

Social Responsibility Scorecard

* For the third quarter of 2002, 12 of the 18 screened funds with $100 million or more in assets, tracked by the Social Investment Forum, received top marks for performance from either Morningstar or Lipper or both for the one- or three-year periods ended September 30, 2002.

* The socially responsible mutual funds tracked by Morningstar received that company's highest rankings (four or five stars) more often than the overall universe of mutual funds.

* Assets in socially screened separate accounts grew by nearly 40%, to $1.87 trillion, from 1999 to 2001.

* Some 230 mutual funds, with $153 billion in assets, currently incorporate social screening into their investment process.

* Socially screened mutual funds retain investor loyalty. Through the first nine months of 2002, when investors put 94% less money into mutual funds, socially screened funds dropped only 54%.

Source: Social Investment Forum, www.socialinvest.org.

Exhibit 1: Shareholder Resolutions

Stockholders frequently introduce resolutions at companies' annual meetings aimed at influencing corporate policy. Here's a sample of some of the resolutions companies faced in 2002:

* Global warming

American Standard
Eastman Chemical
ExxonMobil
General Electric
Occidental Petroleum

* Global labor standards

Unocal
Delphi Automotive
Stride Rite
Sears
Federated Department Stores
American Eagle
Colgate Palmolive
Home Depot

* Sexual orientation discrimination

ExxonMobil
Alltel

* Independent/staggered boards

EMC

Source: Social Investment Forum, www.socialinvest.org.

Exhibit 2: Socially Responsible Investment Resources

* Calvert Group. Includes socially responsible mutual funds and the Calvert Social Index. www.calvertgroup.com/sri_calvertindex.asp.

* Citizens Advisers, Inc./Citizens Funds. One of the nation's oldest and largest families of socially responsible mutual funds, www.citizenfunds.com.

* Domini Funds. A family of socially responsible mutual funds, www.domini.com.

* First Affirmative Financial Network. A registered investment adviser with socially responsible separate accounts and mutual funds programs, www.firstaffirmative.com.

* Investor Responsibility Research Center. Social investing research, www.irrc.com/.

* KLD Research & Analytics. Administers the Domini 400 Social Index and social profiles on more than 600 publicly traded companies, www.kld.com.

* MMA Praxis Mutual Funds. The only church-owned mutual fund family in the United States, it makes investment decisions based on "stewardship investing"--balancing the need to use financial resources productively with a concern for others, www.mmapraxis.com.

* Shareholder Action Network. A clearinghouse of information and analysis on shareholder advocacy, www.shareholderaction.org.

* Social Investment Forum. Provides comprehensive information, contacts and resources on socially responsible investing, www.socialinvest.org.

* Socially Responsible Investing (SRI). A personal finance site devoted to evaluating investments according to social, economic, environmental and corporate governance factors, www.socialfunds.com.

Exhibit 3: Portfolio Screens

Broadly used
(50% or more of screened portfolios)

Tobacco
Environment
Human rights
Employment/equality
Gambling
Alcohol
Weapons

Commonly used
(30% to 49% of screened portfolios)

Labor relations
Animal testing/rights
Community investing
Community relations

Specialty
(Less than 30% of screened portfolios)

Executive compensation
Abortion/birth control
International labor standards

Source: Social Investment Forum, www.socialinvest.org.

Exhibit 4: Adding Social Responsibility to a CPA Investment Practice

CPAs who want to incorporate social investing into their investment advisory practices need to learn more about the discipline and how it fits with their client base. Here are some steps to follow:

* Investigate available resources and establish contacts and sources of investment research in the socially responsible industry. Gather information about available investment alternatives including mutual funds and companies that produce compatible products or pursue acceptable management strategies.

* After gaining the necessary knowledge and expertise, review social investing to see if it makes sense for your firm's client base. Interview clients to examine their values before drafting the investment policy statement that will guide your work with them.

* Incorporate the discipline into presentations to clients and prospective clients by offering socially responsible mutual funds alongside traditional investments in appropriate asset classes. For certain clients consider if community investment or social venture capital is an appropriate way to invest responsibly.

* Track shareholder issues in areas of interest to clients who want to invest responsibly. Discuss with them the option of voting their preferences on proxies for all stocks they own directly. Enforcing ethical and responsible behavior can help improve stock price performance.

* Manage portfolio risk by tracking targets of shareholder activists. Use this information to more deeply analyze companies before purchasing the stock for clients.

CASE STUDY

Is Disregard for the Environment Bad Business?

ExxonMobil's attitude toward climate change is fraught with "unnecessary risks and missed opportunities" that could jeopardize more than $100 billion in long-term shareholder value, according to a study released in May 2002 by Claros Consulting of London, England. According to Claros, here are the risks the company faces:

* Reputation risk. The hit on ExxonMobil's direct brand value could be some $2 billion to $3 billion. Of even greater concern are the broader consequences of a damaged reputation in areas such as staff motivation and political access. These could amount to some $10 billion to $50 billion of market value.

* Litigation risks. ExxonMobil's current strategy exposes the company as an obvious potential defendant in climate-change-related litigation as damage mounts. In years to come, the legal costs alone could amount to $200 million to $1 billion a year. If ExxonMobil is found liable, the damages would be vast--potentially exceeding $100 billion.

* Risks from sudden policy changes. If global warming triggers legislation inhibiting the use of fossil fuel, ExxonMobil would miss profit opportunities by not having transformed itself into a total energy business that includes renewable sources.

The report also outlined five action steps ExxonMobil investors could take to protect their ownership stakes. They include

* Supporting shareholder resolutions on renewable energy sources and on linking executive compensation to social and environmental performance--such as those that appeared on ExxonMobil's 2002 proxy card.

* Pressing the board-of-directors' public issues committee to improve the company's strategy on climate change.

* Asking ExxonMobil for full disclosure of climate-change-related data.

* Requesting financial analysts to evaluate climate change risks at the company.

Other companies, particularly those in the so-called extractive industries, find themselves subject to similar scrutiny from shareholders and advocates for their environmental policies.

CYNTHIA HARRINGTON, CFA, is a financial journalist with 20 years' investment experience. She began her career as a stockbroker and ended it as the owner and chief investment officer of an asset management firm serving high-net-worth clients. Her work appears in a variety, of financial publications. She is a contributing editor of Accounting Today and www.horsesmouth.com, a subscription Web site for financial advisers.