Do Socially Responsible Mutual Funds Engage in Greenwashing?

Pop open the hood of a typical socially responsible mutual fund and it might surprise you what you find.  Often SRI funds, particularly those that invest in the large cap equity space, will hold stock in companies or industries that some SRI investors may find questionable: Oil companies, Too-Big-To-Fail banks and Pharmaceutical companies are all often found amongst the top 25 holdings of many of these funds – not exactly the cutting edge renewable energy and organic food producers an SRI investor may expect to find.

So why is this?  And should these funds still be considered socially responsible?

Well, it depends on your point of view.

There are three main reasons why a socially responsible mutual fund would invest in these types of companies:

1. Screening practices. While most SRI mutual funds will immediately rule out certain industries like weapons manufacturers, tobacco companies and gambling, most other industries can be fair game, particularly if the company in question meets a fund’s positive screening criteria.  So while an SRI investor may not love the idea of owning stock in a multi-national pharmaceutical manufacturer, for example, if that company has adopted business practices that minimize environmental impact while protecting workers’ rights and human rights, it may pass the fund’s screening test.  That said, these terms can be relatively nebulous, so it is up to the fund manager to define what exactly constitutes a company with a “strong environmental track record”.   Since there isn’t necessarily a hard and fast metric for quantifying social responsibility, it’s important to note that standards can differ from fund to fund.

2. Best-in-class. One approach to socially responsible investing is to invest in those companies that are leaders in their particular industry when it comes to corporate social responsibility.  This strategy often targets industries that generally have poor reputations of engaging CSR issues.  The thinking here is, in a sense, to “reward” those companies that place a high value on CSR, with the idea that CSR will benefit the company in the long term and may help to influence wider industry practices.  So while an oil services company may not sound like an ideal candidate for an SRI portfolio, a best-in-class approach would consider that company if it had strong environmental protection measures in place or owned stakes in renewable energy businesses.  This approach affords an investor the opportunity to gain exposure to an industry that may normally be excluded by other SRI funds.  This strategy can backfire spectacularly, for instance with BP.  Before the Deep Horizon disaster last spring, BP had been viewed as one of the few environmentally-friendly oil services companies (whether or not this view was warranted is another issue entirely).   It had been a top choice for best-in-class SRI managers due to its perceived leadership on CSR issues (changing their name from British Petroleum to Beyond Petroleum certainly didn’t hurt that image).  After the devastation to the Gulf of Mexico, and BP’s subsequent mishandling of the clean-up effort, BP’s CSR image was irreparably damaged.  Best-in-class SRI fund managers began dumping the stock and were forced to defend why it was in their portfolio to begin with.

3. Activist investing.  The third reason why an SRI mutual fund would take a position in a company with questionable CSR pedigree is to change the company’s business practices from the inside.  By taking a large stake in a company, the activist SRI manager can gain board seats or file shareholder resolutions in order to push the company towards reforming their business practices.  While the end result can be effective, delivering immediate reforms is often unrealistic since there is generally a long lead time required for an activist investor to change how a company does business.  Often times, fund shareholders can be left scratching their heads when they see the holdings found in an activist investor’s portfolio, so it is important for the shareholder to know why the manager is holding the company and to see what kind of resolutions they have filed on the shareholder’s behalf.

While the above approaches may explain why an SRI mutual fund would hold stock in certain questionable companies or industries, there can still be instances of greenwashing.  So what you do as an investor to protect yourself?

1. Read the prospectus – see what kinds of companies the fund holds.  Make sure you understand their screening process and the criteria they use when selecting an investment.

2. Contact the fund company – if you see an investment in a company engaged in a business that doesn’t meet your social responsibility standards, reach out to the fund company and request an explanation as to why it is being held in the portfolio.

3. Track shareholder resolutions – follow-up with the fund and make sure they are filing resolutions if they say they are.

Like any product that is being marketed to the “green scene”, there will always be those companies looking to cash in on a trend.  It’s up to the investor (and, if the case may be, their trusted adviser) to do his or her own due diligence and not take fund at its word when it uses “socially responsible” in the fund’s name.

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