Recently, after posting a column about BP and socially responsible mutual funds (See Social Funds and BP: How embarrassing!) I heard from Adam Kanzer, who is managing director and general counsel at Domini Social Investments. While Domini has never owned shares of BP, Adam and I began a conversation about the role of socially-responsible mutual funds. Adam, who has been in the fund business for twelve years, is a smart and committed executive, but we don’t always agree, so we decided to engage in a dialog about social funds.
Marc: Adam, let’s start with BP. Why did Domini exclude the company? Do you hold any other oil or coal companies?
Adam: Domini has consistently excluded BP from our portfolios because of our concerns about their safety record. Our initial review followed the Texas City explosion in 2005, but our decision was quickly reinforced by the Prudhoe Bay spill the following year. We met with BP to discuss these and related issues with them. And each time we revisited BP, we found more violations.
We’re looking to identify the key sustainability challenges each company faces. For the oil and gas industries, worker safety and environmental compliance are among a handful of core issues we consider. I should also note that we have consistently excluded Transocean and Halliburton, both of whom played a role in the Deepwater Horizon project. In addition we have also consistently excluded Massey Energy, the other current poster-child for disaster, as well as Toyota for substantial safety, employee relations and human rights concerns. We discuss these decisions on our website. And yes, we do hold other oil and gas companies, although we set a high bar for entry. We do not invest in companies whose core business is coal mining.
Marc: Any thoughts on why BP was so widely held by other socially-responsible funds?
Adam: As CEO of BP, Lord Browne made very important statements about the reality of climate change at a time when others in his industry were denying its existence. That was important. In addition, BP has been committed to transparency on its social and environmental performance. I can’t speak for other firms, but I can see how those factors may have led some to hold BP. We felt that the safety and environmental issues outweighed these positives.
If a fund’s benchmark is heavily weighted towards oil, then an SRI manager will need to consider that. This tyranny of the benchmark certainly led many to hold BP and other oil companies that in a perfect world they would have preferred to avoid.
Which brings me to the important question that I have not heard – why did all of the so-called ‘mainstream’ investors buy BP? Why did investors allow this company to become one of the largest in the world by market capitalization? At least social investors weighed these issues and came to a decision. The rest of the market acted as if there was no problem.
Marc: That’s an excellent point, and it makes me wonder why people pay mutual fund managers such high fees. They missed the housing and Wall Street bubbles, and didn’t see or care about the safety issues at BP. Clearly most funds aren’t very good at managing risk.
Turning to another topic, many SRI funds have their roots in the anti-war movement of the 1960s and 1970s as well as in faith-based investing. So funds like Domini exclude companies that make weapons, alcohol, tobacco and nuclear power. My question is, why? Let’s start with weapons. Don’t we need companies that make weapons in the post 9/11 era?
Adam: First, it is important to understand that we divide those industries into two general categories – companies that provide addictive products and services, and companies whose products contribute to geopolitical instability. We place military weapons manufacturers and nuclear power in the latter category. We do not consider investments in addiction and global instability to be productive uses of capital.
National defense is too important to be placed in the hands of the same system that brought us the financial crisis. When Eisenhower issued his warnings about the growth of the military-industrial complex, he wasn’t questioning our need for a strong national defense. Yes, we need weapons, but do we need publicly traded companies manufacturing weapons? Are the capital markets an appropriate mechanism for providing these goods, or have the markets distorted our national priorities? That’s a critical debate our nation needs to have.
There are also categories of weapons that violate international humanitarian law because they cannot distinguish between military and civilian targets. These include landmines, clusterbombs and nuclear weapons. These ‘products’ make the world more dangerous, and landmines have caused incalculable misery to innocent civilians – including children – around the world. As investors, we have a responsibility to choose wisely. Our Funds’ shareholders choose not to profit from these violations, so we exclude these manufacturers and companies that manufacture nuclear weapons delivery systems.
Marc: What about nuclear power? Some environmentalists, notably Stewart Brand, say we need to seriously consider nukes in light of the climate crisis?
Adam: Before nuclear power can be seriously considered to be an effective answer to climate change, we need to solve the nuclear waste problem and we need to address the link between nuclear power and nuclear weapons proliferation. To date there is no way to distinguish between the uranium enrichment process that is necessary to fuel a nuclear power plant and the enrichment of uranium for use in a nuclear bomb.This is an issue that Amory Lovins raised decades ago, and it has only increased in importance since then. The risks and the upfront costs of nuclear power are still, in our view, far too high. I believe this is still the ‘mainstream’ view among environmentalists.
Marc: So you don’t like nukes or coal. Do you invest in any companies that provide the baseload power we need to run our lives (including this blog!)?
Adam: Yes. We do invest in energy companies, such as AGL (Australia), EOG and Noble.. We have also approved utilities, such as National Grid, but evaluate the source of the energy. We review each industry and subindustry against a set of corresponding key indicators. For example, we would look at a water utility differently than a company involved in natural gas distribution and transmission, or a nuclear or coal-based utility. And, of course, we’re looking for companies with significant commitments to renewable energy such as wind and solar power generation.
Marc: You mentioned addictive products–do you exclude Starbucks? Coffee’s addictive, right?
Adam: We’ve consistently approved Starbucks. We do not place caffeine addiction on the same level as alcohol, gambling or tobacco addiction in terms of harm to society. It doesn’t distort your decision-making and impair your daily functions in nearly the same way.
Marc: Let’s talk about performance now. Many of us want to invest in ways that are consistent with our values. That’s why I’m a shareholder in the Domini Social Equity Fund. But we also want to maximize our returns.
Generally speaking, SRI funds have tracked broader market indexes, running slightly ahead during some time periods and behind during others. Domini Social Equity, for example, has averaged a –1.02% annual return over the five years ended on June 30, 2010, compared to –0.79% annual return for the S&P500, meaning that an investor would have done slightly better with an index fund.
If I’m not mistaken, you and I share the belief that companies that are socially and environmentally responsible will provide superior shareholder value in long run.So I’m wondering–why haven’t social funds, as a group, outperformed?
Adam: First, if you want an apples to apples comparison, you might want to look at the S&P 500 Index versus the FTSE KLD 400 Social Index, which now has a 20-year track record. From May 1, 1990 through July 31, 2010, the S&P had an annualized return of 8.39% and the KLD 400 an annualized return of 9.14%..
Whether this outperformance on an index-to-index basis will continue is anyone’s guess, but there’s absolutely nothing wrong with simply tracking broader market averages, without outperforming. That means you can do just as well by investing responsibly, and that’s certainly good news.
We have never made any claims that SRI will always outperform. There are times when greed, dishonesty and environmental destruction pays. The market does not consistently reward responsibility, or punish irresponsibility. I think Gap is doing a great job addressing labor conditions in its supply chain, for example, but that doesn’t necessarily mean that the next style they introduce will be well received. Compare BP to Shell. A decision to avoid BP was only rewarded after disaster struck. Meanwhile, the New York Times reports that Shell has had the equivalent of an Exxon-Valdez oil spill in Nigeria every year for the past fifty years. That doesn’t seem to be reflected in Shell’s stock price. Incidentally, we have also never approved Shell for the Domini funds.
We need to be very careful on two fronts here. First, we must never overstate the potential for long-term performance of SRI funds – or any investment strategy for that matter. There are many factors that can affect a fund’s performance over time, including the fund manager’s expertise. When SRI funds underperform in a particular time period, they often do so for the same reasons many actively managed funds underperform. We do believe that social and environmental factors are financially material and can help us to identify better long-term investments, but the market is not always going to reward these particular characteristics.
Second, we need to begin a more important conversation about what it means to earn a ‘responsible’ rate of return. What are the appropriate benchmarks? Why do I need to demonstrate that I can outperform a benchmark dominated by polluters and human rights violators?
What do you mean when you say we wish to ‘maximize’ our returns? Certainly not at any cost? If I could guarantee you a 1,000% return on a direct investment in genocide, I’m sure you wouldn’t have any problem passing up that opportunity. Profit ‘maximization’ is another one of those myths that needs to be exposed. Nobody is truly seeking to ‘maximize’ returns. I would prefer to see a national discussion on the ends we wish to achieve through our investments, rather than this rather narrow discussion of whether SRI can perform. Yes, it can. That’s only the beginning of the story.
The definition of success in investing as outperforming a benchmark is ultimately weak and incomplete. Surely investing has something to do with creating real value—a stable, equitable society moving toward ideals of justice and sustainability. If we define success in investing simply as beating your neighbor, even if the market as a whole or society as a whole is suffering significant losses, I think we have drained the activity of all intrinsic value.
Marc: Interesting points. Of course no one wants to maximize returns at any social and environmental cost. But I don’t agree that there’s a tension between doing the right thing and doing well as a business, at least in the long run. if you don’t believe that over time, companies that are most socially and environmentally responsible will outperform their peers, then we are both fighting a losing battle when it comes to changing the way business is done.
I’ve always longed for an SRI fund that would do deep research and select 20 to 30 leading companies—companies with strong values and solid businesses—with the belief that those companies would, in fact, outperform the market as a whole. I wrote about companies like Starbucks, Southwest Airlines, Timberland, UPS and Domini in my book, Faith and Fortune, and they were all top performers in every sense. (I picked HP, too, which hasn’t turned out so well.) What do you think of a focused SRI fund that selects a small number of the best companies?
Finally, you write that “we must never overstate the potential for the long-term performance o SRI funds,” but don’t you find it strange that the SRI funds are about the only mutual funds out there that don’t claim to be the best way to invest?
Adam: You’ve packed a number of important points into that question, so let me try to take them one at a time.
First, I’m glad you agree that no one wants to maximize returns at any social or environmental cost. But I see very little evidence of that thinking outside of a relatively small group of investors. BP and Massey are the latest examples – investors were quite happy to own their stock despite their miserable safety records. PetroChina’s connections to genocide have not led to a mass exodus by investors.
So let me rephrase my statement slightly. When I say nobody really seeks to maximize return, I mean that virtually everyone places some limitation on that quest for profit. We all impose some sort of limit on that “profit maximization” objective. Milton Friedman would say profit “within the rules of the game”, but didn’t define what those rules were. Social investors, and most ordinary rational human beings, would say “without harming others.”
It’s a fairly simple concept that is still largely absent in mainstream investment circles. Financial theory has established financial risk as the only meaningful limit on profit maximization. It is an inherently amoral, and therefore inhuman system. Thankfully, this attitude appears to be changing. I would strongly disagree that we’re fighting a losing battle. To me, the evidence suggests that we’re winning.
I think it is also important not to get caught in the trap of measuring performance solely in financial terms. Some companies provide greater social and environmental benefits to society than others. Markets may recognize that fact at some times and fail to recognize it at others. But we at Domini invest to achieve a combination of the two—both the social/environmental benefits and the financial return.
Domini does believe that companies with stronger social and environmental profiles should perform better in the long term, and that the use of social and environmental factors can help manage certain types of investment risk. We do believe it is a better way to invest, as well as a more rational, civilized, humane and ultimately beneficial way to invest.
If we sell SRI purely on this concept of ‘outperformance’ we will lose investors the moment the markets turn. SRI is not the latest get rich quick scheme. Social investors tend to stick around, rather than pursue the latest performance fad, because they understand this is a systemic answer to global problems.
Your idea for a focused ‘good guy’ fund is an interesting way to hold out exemplars of good corporate behavior, but it largely ignores the crux of the problem. We can’t simply ignore mid-cap and-large cap companies because they don’t currently meet our definition of purity. Unless you’re willing to say that it is inherently irresponsible to invest in large companies, then large cap investors need responsible options as well. Investors should not have to give up the opportunity to invest as responsibly as possible in well-diversified portfolios of large-cap companies, and they certainly should not give up the opportunity to engage with those companies and move them towards more sustainable business models.
Is SRI the ‘best’ way to invest? That depends on your definition of ‘best’ and the benchmarks you use to make that determination. Once you recognize that our investment decisions have an impact on the world, however, you come to accept that it is not appropriate to ‘outperform’ while destroying ecosystems and harming people. And in that sense, SRI becomes the only way to invest.
Marc: Adam, thank you. Maybe I’m asking too much, but I think it’s desirable–and possible–for a fund to deliver superior financial, social and environmental value. In the meantime, best of luck with your good work at Domini.