Paul Hawken’s article on socially responsible (SR) mutual funds has stimulated an emotional debate that seems headed in the wrong direction. SR mutual fund defenders have responded that the SR investment industry is doing the best it can within the limitations of the existing system. They argue what few can dispute: that every little bit helps. We don’t disagree that a little is better than nothing, or that those who participate with good intentions should be faulted for not understanding the complexities of global finance and the mutual fund industry. Thanks to Paul Hawken for raising critical questions that demand self-scrutiny. These questions will stimulate yet more effective approaches to socially responsible investing.

Missing from this discussion is an examination of equity investing as an effective model for promoting socially responsible business. In addition to asking how best to invest in mutual funds, we should also be asking whether and how equity investment, i.e., the purchase of shares of a company on the open market, promotes sustainable communities and enterprises. We all seem to be quibbling about how to select among less-than-optimal mutual fund choices, while overlooking that investors could call for another approach altogether, such as investment in the loans, notes or bonds that directly fund enterprises.

The defense of SR equity investment hinges on two points: 1) through the purchase of fund shares, individuals give an economic vote of confidence to the companies whose shares are in the fund portfolio; and 2) their blind ownership vests a power of influence on the SR mutual fund managers who, by proxy, vote their values, thereby influencing the management of companies to operate responsibly.

On the positive side, many argue, diligent shareholder activism encourages positive change. Unfortunately, the converse also holds true in that shareholders also can negatively influence the most socially minded and responsibly managed company. Moreover, even when a company enjoys ownership by conscientious managers and shareholders, a day generally arrives when shareholders divest. When a majority of company shares can be purchased on the open market, no real controls exist to ensure that future shareholders will demand that a company conform to sustainable or socially responsible principles.

The appeal of equity investments as socially responsible resides in the desire to have it all — high returns and businesses operated according to SR tenets. The investor exercises influence as an owner, and as the economy grows, so grows the value of the investment. The investment may be a gamble, but the opportunities for return presumably offset the risk. That investor will realize a return in increased dividends (if the company offers them), or through the increased value of the share when it is sold (which then forfeits that ability to exercise shareholder oversight of the company).

For the enterprise owner, the appeal of equity investment resides in an opportunity to obtain needed start-up or expansion capital without the contractual strings of a loan. The owner who finances through the sale of shares still is bound by strings of obligation, but they are undefined and unpredictable. If the enterprise is successful, shareholders will expect to enjoy a return on investment, either in cash dividends or price appreciation. Those undefined and unpredictable strings can be pulled in a range of ways, sometimes not to the advantage of the original founders or in keeping with their vision and values.

Theoretically, equity shareholders have the ability to stimulate positive changes in the ways that business is undertaken, but this seems, at best, an indirect and unpredictable influence. Until the values of the SRI community have permeated the global financial culture, and every shareholder and fund manager seek the same SRI goals, the effect of this approach to investment and funding businesses may be inconsistent, transient and uncertain.

If we seek to identify a truly just approach to achieving investment income and funding worthy enterprises through investment, we should look to fixed-income investments in loans, notes and bonds. These vehicles offer the possibility of a truly transparent investor-investment relationship in which all stakeholders understand the terms of the exchange. In debt instruments (i.e., fixed-income investments), investors know their expected investment returns at the outset, while borrowers understand their obligations to lenders. The advantage of debt financing for the socially responsible business operator is that control of organizational values and business methods is maintained. For the socially responsible investor, the opportunity to exercise an activist influence is achieved by attaching conditions under which the loan is granted. These conditions, or covenants, could stipulate such matters as environmental safety, employee rights, and competitive and sustainable practices.

The recent focus on mutual funds as a vehicle for socially responsible equity investing is understandable because mutual funds are widely available to both large and small investors. Unlike mutual fund investments, however, few opportunities exist to invest in loans or bonds that support social enterprises. One exception is community development investing, which focuses on housing and small business in primarily low- to moderate-income neighborhoods. Community development investment vehicles are gaining momentum as individual and institutional investors recognize valuable social and economic returns. They fill an important financial niche, but operate within a regulatory structure that limits their ability to invest broadly in emerging or existing social enterprises. More options are needed.

Why do so few opportunities exist to participate in socially responsible fixed-income investments? Like mutual funds, the underwriting of loans and the issuance of bonds are undertaken with the assistance of financial intermediaries, through which investor dollars are funneled to the end recipient. Unlike mutual funds, the intermediaries that underwrite loans or bonds have an added responsibility of assuring investors that the principle and interest will be repaid as contractually agreed. The diligence associated with such an undertaking is far more comprehensive and costly than underwriting a stock offering. This greater cost figures in the reason why opportunities are scarce for investing in socially responsible debt instruments.

In the global financial markets that support mainstream business through fixed-income investments such as loans or bonds, participation by both investors and recipients is governed by transaction size (the dollar amount of the bond issuance), transaction volume (the number of times a bond is reissued), and trading volume (the number of times a bond is resold after it is initially issued). Typically, global finance intermediaries engage in very large transactions that generate the greatest earnings per transaction. Thus, a small mainstream bond issuance may be $250 million, and more typically $1 billion. Social enterprises requiring financing ranging from tens of thousands to several million dollars are far too small to be funded by the mainstream market.

Unfortunately, today’s socially minded investors exist in an investment vacuum. Even though many would welcome opportunities to enter into fixed-income investments supporting social enterprises, the social finance structures needed to enable this simply are lacking. Within the mainstream finance market, investors can compare investment opportunities, invest using a relatively easy process and liquidate their assets when they wish to use their money in other ways. This process is possible through the existence of a complex web of entities that operate invisibly to most investors. These entities — rating agencies, transfer agencies and market makers — create conditions that enable easy investment in, for example, mutual funds.

Notable to this discussion, although individual organizations have attempted to rate SR fixed-income investments and establish SR fixed-income investment transfer (primarily by the National Community Capital Association and Calvert, respectively) no comprehensive system exists for rating, transferring and trading such investments. This absence figures as one key element limiting the wide availability of socially responsible fixed-income investments. The leaders of the SRI movement will privately acknowledge the operational and regulatory challenges of meeting private client requests for SR fixed-income investments due to this void. While they may publicly point to efforts to provide fixed-income investments, in aggregate, their efforts don't approach the magnitude of the opportunities of the mainstream market.

Tackling the problem of inadequate SR fixed-income investment opportunities will come from several directions. One obvious action will likely emerge as private groups of affluent investors pool their assets to create innovative lending opportunities. These vehicles likely will not be available to small investors with a few thousand dollars to commit or attractive to institutional investors with billions of dollars to direct. Their participation will come about when the entities that rate, transfer and help keep the investment market liquid are developed and applied to the social-finance realm. Some of this is already beginning to happen.

The SRI community has a tremendous opportunity to transform the ways that investors support the growth of emerging and existing socially responsible businesses. One of the greatest ways to stimulate change is through education. The global finance market is complex and dense, and its understanding eludes even its sophisticated participants; thus, it is crucial that the SRI community continue to educate itself, to ensure that we all understand exactly what our money does when we opt to store it in places other than our mattresses. The discussions here in Dragonfly Media about socially responsible investing and mutual funds have demonstrated a high interest in understanding the workings of the financial marketplace. We thank Dragonfly Media for creating the forum and enabling the continuation of the discussion.

Return to the SRI Discussion Index Page

Read Responses To This Article

Recommend This Article To A Friend

Top