The quest for investment success is no one's idea of a picnic, but conventional money management can look like child's play compared with navigating the hurdles of socially responsible investing (SRI). Managers in the niche are still expected to generate decent if not stellar returns while keeping a lid on risk. They're also charged with satisfying ethical, social and/or governance (ESG) goals. Mastering this multi-track challenge is tough under the best of circumstances, and it doesn't get any easier within the framework of one-size-fits-all products that try to be all things to all investors.

That hasn't slowed efforts at trying to squeeze the wide-ranging ideals of SRI into a single vision. The universe of socially responsible funds (mutual funds, ETFs and other pooled products) reached nearly 500 last year, collectively holding $569 billion, according to the US SIF: The Forum For Sustainable and Responsible Investment (US SIF). That's up sharply from 55 products and $12 billion under management in 1995. Much of the growth has been unleashed in recent years. Since 2005, assets in SRI products have popped by roughly one-third versus just 3% for the broader universe of professionally managed portfolios. What's driving the faster pace? Clients are increasingly asking money managers to integrate SRI factors into the investment process, according to US SIF. 

No wonder that the business of prepackaged SRI products is a growth industry. But the popularity of generic solutions doesn't diminish the allure of custom strategies, advocates say. "The more you can customize a portfolio, the more the client can see their value concerns reflected in the portfolio," says Michael Lent, chief investment officer of Veris Wealth Partners and chairman of the board at US SFI.

"Socially responsible investing is powerful when clients can see their values reflected in their investments," explains Craig Muska of the Threshold Group, a wealth manager that specializes in SRI. "Our role as an advisor is to implement the client's perspective." That's easier with customized portfolios, he says, because building an investment strategy from scratch means that the investment mix is "specifically about the client."

That's true for any investing plan, of course, but it resonates deeply with SRI. Social values are intensely personal and so the notion of giving the client what she wants is a natural extension of this investing philosophy. "Within the psychographics of this audience, there's an assumption of a certain level of customization," says Sam Pierce, CEO and president of IW Financial, an ESG research firm.

SRI generally isn't the norm in money management, at least not yet, and so it's hardly surprising that investors in this corner are expecting a higher level of personalization. Why, then, are SRI mutual funds so popular? Convenience is one reason. Muska says he uses publicly traded SRI funds for investors who can't or won't define their social and ethical objectives in sufficient detail. "For some clients, off the shelf is great," he notes. Nonetheless, Muska holds his advisory role to a higher standard. "My job is to help clients define their version of social responsibility and help them understand the trade-offs." 

The Economics Of Getting Personal

For clients who are willing and able to go the extra mile in mapping out their SRI views, the benefits of customization are self-evident. "You get exactly and only the values that matter to you as an investor," says Patrick Geddes, chief investment officer and co-founder of Aperio Group, which customizes SRI strategies for institutions and advisors around indexing strategies. "You don't get someone else's value." Or someone else's proxy votes. Upon request, Aperio also arranges for proxy voting for the underlying securities in accordance with the client's social goals. 

The primary beneficiaries of customization are the clients, of course, but it also brings advantages for financial advisors. "If you come up with a custom solution for client needs, you build a relationship of trust," says IW Financial's Pierce. "That's one of the real benefits for advisors."

The process of interviewing investors to learn the details of their preferences, and how those choices translate into portfolio design, promotes a stronger bond between advisor and client. Building custom SRI portfolios "certainly has solidified relationships and probably expanded relationships," says Hilary Giles, a wealth advisor at Merrill Lynch's private investing and banking division in Menlo Park, Calif. "We know the clients on a much richer level than we did before."

Another advisor reports that designing custom portfolios helps distinguish his firm from the competition. "It helps me break away from the herd mentality," says Brad Pappas, president of Rocky Mountain Humane Investing. As an example, he says there's greater flexibility for managing risk with individually designed strategies. "What really makes us different is the ability to hedge positions, which mutual funds won't do." He notes that gold was recently a top holding, adding that he also uses inverse exchange-traded funds in some SRI portfolios. 

Even for advisors with less racy notions of portfolio management, there's more flexibility in the land beyond publicly traded products. "Nine out of ten SRI funds are growth funds," complains Pappas.

Financial issues aside, Muska reckons that offering personalized SRI portfolios is just good business because it's a response to customer requests. "There's an increased interest in customization, particularly among our client base."

Building portfolios individually for clients isn't necessarily a free lunch, however. For starters, minimum investments for customized SRI strategies are higher than they are for mutual funds and ETFs. Pappas, who researches and builds portfolios in-house, says he'll consider new accounts with as little as $50,000. By contrast, you'll need at least $250,000 to open the management door at Parametric Portfolio Associates, a quantitative money manager that customizes SRI index strategies, says Kurt Galley, the firm's managing director.

Costs vary as well, although sufficiently large portfolios may benefit from economies of scale, perhaps to the point of keeping expenses competitive with mutual funds. And for customized SRI strategies that are also designed to mimic indices, there can be substantial savings relative to actively managed counterparts.

Advisors who choose the custom route should also be prepared to grapple with the finer points of turning a client's broad ideals into specific investment choices. Embracing a particular ESG cause can be clear-cut in concept, but the details of selecting securities can get messy. Companies and industries that are considered "green" in the abstract, for instance, can turn out to be polluters of some degree upon closer inspection. Meanwhile, firms that are widely demonized as environmentally clueless may be responsive and transparent on certain topics of concern to green investors, a plus that can boost the company's score in some SRI rankings. 

It's easy to say you're against pollution. How does that translate into an investment strategy? It depends on the client, of course, which is to say that the proverbial gray area is always lurking. Most firms, for instance, have a carbon footprint and so they're contributors to greenhouse gas emissions. How much is too much? The choices would be easier to navigate in the absence of the usual expectations about money management. But unless you're advising clients who can afford to place little or no value on investment performance, tough choices usually await for the trade-offs between satisfying ideals and earning decent returns. 

One lesson from veteran consultants is that a no-tolerance stance on SRI principles is rarely practical from a financial perspective. Compromise is inevitable for most clients. But in what form and degree? The possibilities are endless. Using pollution as an example: Should you avoid the worst offenders? Or is it better to emphasize firms that have made the most progress in reducing greenhouse emissions? If so, what standard will you use? Does the proactive oil company that's making progress in cleaning up its act rate higher than a careless manufacturer of environmentally friendly solar panels? As clients and advisors quickly realize, there are no absolute answers.

Indexing SRI Preferences

One approach to bringing some order to the chaos of choice is filtering a client's preferences through an SRI database that ranks companies on dozens if not hundreds of factors, such as labor relations, human rights, environmental standards, etc. For example, IW Financial (one of several ESG research firms) analyzes, scores and updates rankings on more than 5,000 firms for roughly 1,000 distinct data points. Slicing and dicing the investment arena through the prism of such databases is the raw material for helping advisors and institutions quantify an investor's social values and build portfolios that satisfy specific agendas.

Advances in financial technology make it easier to translate a client's preferences into real-world portfolios. That opens the door for customizing SRI strategies around indexing, which at its core is a quantitative strategy. For that reason, indexing and SRI are considered by some to be complementary.

"We think it's really difficult to take an active strategy and overlay SRI restrictions on it," says Parametric's Kurt Galley.

One of the rationales for marrying indexing with SRI (beyond the standard arguments for passive investing) is that the combination enhances control over the inevitable trade-offs that arise in pursuing a particular preference versus earning the highest return possible for a given level of risk. Estimating where those trade-offs lie, and how much they'll help or hinder a client's cause, is harder when looking through the lens of active management.

"There's nothing inherently wrong about combining active management and ESG, but investors are unclear about what they're getting and why their managers are doing poorly or well," says Aperio's Geddes. Active SRI managers are quick to argue otherwise, although most independent analysts recognize that alpha and beta are easily confused outside of indexing, and SRI is no exception.

Geddes explains that his firm builds customized SRI portfolios according to client wishes while simultaneously focusing on replicating the risk/return profile of any number of equity indices-the Russell 3000 for U.S. stocks or MSCI EAFE for foreign markets, for instance. The challenge is minimizing tracking error (a measure of how closely a portfolio mimics its benchmark) and maximizing an investor's social goals. 

In other words, there are costs for pursuing a socially responsible strategy. Or, in the parlance of quantitative investing, SRI is a strategy of factor tilts-and not by accident. Intentionally sidestepping certain investments and emphasizing others is part and parcel of the SRI world. But preferences have consequences on at least two dimensions. One is axiomatic in this realm. Designing a portfolio according to a set of ESG principles-i.e., diverging from the norm-is the sine qua non of the social payoff. A "green" investor holds a different portfolio than the average investor-no explanation required. 

But a satisfying qualitative outcome doesn't necessarily ensure a successful financial result. It's one thing to accept a higher tracking error as the price for SRI. But are you clear on the trade-offs? Owning the S&P 500 ex-energy, for instance, will obviously be different than owning the standard index. But there's still the question of whether you're likely to suffer more risk (or earn less return) than necessary in pursuit of certain SRI preferences. It's hard, or at least harder, to know with active management because the distinction between alpha and beta can be murky. Geddes says that the tracking error for active managers generally is roughly 5%, or well above the low 1% area for Aperio's custom SRI portfolios that track conventional equity benchmarks. 

It's easier, of course, to pick an existing SRI mutual fund or two and be done with it. But that's not necessarily an optimal choice for all clients. It's not particularly helpful for an advisor's value proposition either. "To attract assets, you have to offer something unique to people," Pappas says. 

Recommending mutual funds that are available to everyone has its place, even in SRI. And to be fair, there are a growing number of publicly traded products that offer a wider selection of relatively narrow ESG solutions. But public funds overall aren't likely to distinguish an advisor's practice. Even worse, there's a risk that the products selected may not satisfy the client. In an increasingly competitive landscape for financial services, that's a potentially dangerous combination.