Question from Julien through our GenYmoney Facebook group: How can I align my investments with my values?
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Benjamin Felix is an associate portfolio manager with PWL Capital in Ottawa.
Answer: One of the most direct ways that investors can align their investments with their values is through impact investing. Impact investing typically occurs outside of the public financial markets, and involves making direct investments in businesses and social enterprises that have a positive social or environmental impact (and hopefully a positive expected financial return).
While impact investing may provide the most direct alignment with your values, it can be risky and challenging to properly diversify. Something like CoPower’s Green Bonds might play a role in your portfolio, but it’s probably not a standalone solution to achieving your long-term financial goals.
It is possible to invest in public financial markets in a way that aligns with your values. There are plenty of exchange-traded funds (ETFs) and mutual funds that apply screens to stocks that they hold. This type of investing is referred to as socially responsible investing (SRI). There are SRI investment products to address all sorts of social concerns. These investments inevitably come with higher explicit and implicit costs.
Explicit costs
SRI funds typically have higher fees than traditional index funds – there is more work required to filter out certain types of companies. For example, the iShares Jantzi Social Index ETF (XEN) follows a Canadian index that screens out companies with low environmental, social and governance (ESG) scores, and companies with exposure to military contracting, nuclear power, and tobacco.
XEN has a management expense ratio (MER) of 0.55 per cent. In contrast, the iShares Capped Composite TSX Index ETF (XIC), which tracks the broad Canadian market without any SRI screen, has an MER of 0.06%. That is an explicit cost difference of almost $500 per year on a $100,000 investment. To be fair, XEN has outperformed XIC over the past 10 years, but that can mostly be attributed to small-cap stocks underperforming in Canada over that period.
Implicit costs
We cannot predict whether an SRI index fund will have better or worse long-term performance than a traditional index fund. What we can say for sure is that by screening out certain stocks, SRI inherently reduces diversification. To illustrate this, the iShares MSCI ACWI Low Carbon Target ETF (CRBN) consists of 88 per cent large-cap stocks, 12 per cent mid-cap stocks, and zero per cent small-cap stocks, while the FTSE Global All Cap ex Canada Index ETF (VXC) consists of 76 per cent large-cap stocks, 18 per cent mid-cap stocks and 6 per cent small-cap stocks. It is well documented that small-cap stocks have higher expected long-term returns than large-cap stocks, and that they offer a diversification benefit in a portfolio. Omitting exposure to small-cap stocks might reduce your long-term expected returns.
Who says it’s socially responsible?
Slapping a label on a product that says “socially responsible” or “low carbon” might be enough to attract some investors, but it does not mean that the underlying companies are going to align with your values. For example, Tim Nash, The Sustainable Economist, analyzed the Jantzi Social Index compared to the S&P/TSX 60 and found that it barely scores any higher in terms of ESG scores, and it contains some companies that most SRI investors might want to avoid. Nash found similar issues with other investments that claim to be socially responsible. It is important to remember that your definition of social responsibility may differ from the fund manager’s.
Are you really making a difference?
I can’t tell you what investment decisions should make you feel good, but the truth is that when you purchase shares in a company on the secondary market, that company is not actually receiving your dollars – that only happens in the initial public offering (IPO). You are still benefiting from its growth, which may make you uncomfortable if you feel strongly against the company. Considering the higher costs and potentially lower expected returns of SRI investing, some people may choose to invest in traditional low-cost index funds and donate the cost/expected return difference to charitable causes of their choice.
This approach puts the decision about which causes to support in your hands instead of the fund manager’s, and it also results in a tax credit. This is of course a very personal choice, but it is important to consider that there is a cost to SRI investing, and those dollars could be used to express your values in other ways.
Today, it is possible to build a socially conscious portfolio of index funds that is reasonably well-diversified and low-cost – the Organic Couch Potato has an MER of 0.39 per cent, but it will not be as well-diversified or low-cost as a traditional Couch Potato portfolio – the Assertive Couch Potato has an MER of 0.15 per cent. SRI investing puts the choice of what is socially responsible in the hands of a fund manager. An alternative approach may be to stick with traditional index investing, and use the difference in cost/expected return to support causes directly.
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