Original MoneySense.ca link: http://www.moneysense.ca/columns/index-investor/couch-potatoes-can-have-a-conscience

I can’t deny it: some of the companies in my ETF portfolio do disgusting things. They manufacture cluster bombs, cut down rainforests, spill oil in oceans, treat employees like slaves, or even—horror of horrors—sell high-fee investments.

I’ve made my peace with this. The index funds in my portfolio include tiny holdings in more than 10,000 stocks. My stake in any one of these evildoers is tiny, and I don’t feel I’m contributing to their misdeeds simply by holding a few of their shares. But I get many emails from readers who don’t share this view. They want to know if they can combine the Couch Potato strategy with socially responsible investing, or SRI.

I took that question to Timothy Nash, president of Strategic Sustainable Investments in Toronto and the blogger behind SustainableEconomist.com. “I see a lot of overlap between the two strategies,” Nash says, “primarily in the sense that both are about sustainability and thinking about the long term.”

Nash helps clients build diversified portfolios that reflect their values without picking individual stocks. He recommends funds like the iShares Jantzi Social Index Fund (TSX: XEN), the only ETF in Canada with a socially responsible mandate. The index ranks firms according to their environmental, social and governance records, excluding the 20% with the lowest score in each sector. This lets investors get broad market exposure while avoiding the worst companies. Other index funds go even further: the iShares MSCI Socially Responsible ETF (NYSE: DSI) excludes U.S. companies that profit from alcohol, tobacco, weapons, nuclear power or gambling.

This example is the biggest problem with SRI indexes: they have built-in value judgments. Surely I’m not the only investor who sees a big difference between firms that make assault rifles and those that brew beer. Many environmentalists believe nuclear power is cleaner than fossil fuels. An index provider’s idea of “socially responsible” may be a lot different from yours or mine.

That unease is shared by Meir Statman, a professor of finance at Santa Clara University in California, who has done extensive research on SRI. “How close do you want to get to your values?” he asks. A generic SRI index is cheap, while the research and selection process involved in a personalized solution can be costly. “If you want a portfolio that really reflects your values, you’ll end up paying a whole lot more. In the same way you can pay $3,000 for a custom-made suit, or $300 for an off-the-rack suit that fits reasonably well.”

For his part, Statman isn’t willing to pay for a made-to-order portfolio—he would rather use plain-vanilla index funds and donate more to his favourite charities—but he respects those who feel differently. In his book, What Investors Really Want, he uses an analogy: imagine telling an Orthodox Jew that instead of keeping kosher he should buy cheap cuts of pork and donate the savings to his synagogue. It’s equally disrespectful to tell an environmentalist she should invest in chronic polluters to save fees if that notion is deeply offensive.

Timothy Nash agrees some investors put conscience before cost. “Many of my clients work in the non-profit sector, and if you’re working for an environmental or social justice organization day in and day out, and your pension plan invests in oil sands companies, there is a gap there.”

Nash says some investors in SRI funds want to have a meaningful impact on corporate behaviour by exercising their votes at shareholder meetings. “In traditional mutual funds, the default policy is simply to vote with management. But if an SRI fund is dedicated to shareholder engagement, your vote will be used to push that company toward greater transparency, greater disclosure, greater sustainability.”

The key is finding out whether your SRI index fund actually does this. The iShares Jantzi Social Index Fund is not involved in shareholder engagement, but the Meritas Jantzi Social Index Fund—tracking the same index—has a long record of advocacy. Again, you pay for this benefit: Meritas sports an MER of 2.23%, versus 0.55% for the iShares ETF. (Socially responsible ETFs offered by iShares in the U.S. do include active shareholder engagement.)

Nash’s suggestions for an “Organic Couch Potato” portfolio include XEN and DSI to cover Canadian and U.S. equities. The Pax MSCI EAFE ESG Index ETF (NYSE: EAPS) is a socially responsible fund that invests in international companies. No bond ETF follows SRI principles, but the PH&N Community Values Bond Fund is a low-cost actively managed alternative. If you want to avoid corporate debt altogether, try an ETF of government bonds or a ladder of GICs for your fixed income.

All investors should pay attention to diversification and low costs, but no suit fits everyone perfectly. Your strategy should deliver a financial return but still let you sleep at night. As Nash says, “It really comes down to integrity and aligning your investments with your values.”