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Most of us want to be “socially responsible” — however we define that. We don’t want to trash the planet for our children and grandchildren. We don’t think corporations should exploit their workers or their communities. And we don’t intend to profit from the misery of other human beings.

Yet most of us also need to provide for our retirement by holding shares in the world’s economy. If we fail in that task, we’ll be a burden to others in our old age, creating a different set of problems….

Are these goals — social responsibility and financial independence — compatible? How can small investors live up to their ideals without compromising the financial freedom they’ve spent a lifetime achieving?

I’ve wrestled with these questions, off and on, for much of my investing career. I had a difficult time answering them years ago, and I have a difficult time answering them today. But, given some intervening years, and another round of research, I’m a bit smarter about the options. Perhaps what I’ve learned can help you make your own peace with securing and growing your wealth, while causing the least harm….

The Problem with Index Funds

Virtually all of today’s independent financial experts recommend a broad-based passive index strategy for investors, large or small. By keeping your expenses low and investing in the entire market, rather than choosing individual stocks, you have the best chance of avoiding financial disaster and reaching your goals. In particular, you sidestep the performance-sapping siren song of Wall Street’s active investment managers, who have proven, in wave upon wave of research, to consistently underperform the market.

But, if you are concerned about the state of the world, there is a hidden flaw in a strict passive index investing strategy: In buying those broad indexes, you own small pieces of most of the public companies in the U.S., or the world. And that means, in addition to owning many responsible firms that offer valuable products and services while caring for their employees and stewarding the environment, you also own some scoundrels.

The usual suspects include tobacco, alcohol, adult entertainment, firearms, gambling, and nuclear power. Maybe those bother you, maybe not. Everybody has his or her own definition of “responsible.” In addition to those common “sin” stocks, some investors don’t care for oil companies, or pharmaceutical companies, or fast food companies. But none of those is necessarily excluded by the typical socially responsible Environmental, Social and Governance (ESG) filters.

Pros and Cons

Should you try to eliminate all objectionable companies from your portfolio? There are valid reasons not to make that effort:

You and I are not big institutions with billions of dollars in holdings that could actually influence corporate behavior. You have to sell a lot of stock to get the attention of a major company. For a small investor to move his 5- or 6-digit life savings out of an individual stock, much less a mutual fund, is a symbolic gesture. It’s not going to affect the companies involved, and it’s not going to improve the world measurably. In fact, selling stocks actually makes them a better value for others who don’t share your values to buy and profit.

Labeling complex modern corporations as “good” or “bad” is an exercise in ambiguity. Most socially responsible mutual funds are driven by committees that score and rank stocks on a host of ESG factors. That means you’re putting your money into what somebody else thinks is ethical. Their values may or may not reflect yours. When I review the top 10 holdings of various socially responsible funds, I invariably spot a company that I find objectionable, anyway.

I asked Mr. Money Mustache for his take on socially responsible investing. He is one of the most influential voices in personal finance, with impeccable credentials as a champion of low-cost, planet-friendly lifestyles. His reply: “I just don’t focus on the investment side of it too much at this point since there is much more leverage on the consumer spending side. If people only bought renewable energy and valued ethics, even Exxon would transform overnight into an ethical solar company – because that would be where the money is.”

Exactly. For all the sanctimony of those peddling socially responsible investment products, the ultimate power for change lies in the hands of consumers. The world is more likely to be transformed on the demand side than on the capital side. Industries are created based on what people want and buy. Manage our desires better, and a host of social problems will go away on their own.

Broad index funds represent shares in the world economy. That’s not an explicitly evil choice, in my opinion. It’s the best place for most small savers to build wealth. If we want that world economy to be more ethical, then Socially Responsible Investing (SRI) might be part of the solution. But the leverage is low, in my opinion, compared to taking direct action on social causes, or simply living a more frugal life.

That’s not to say there aren’t good reasons for pursuing SRI: You may have strong personal beliefs around corporate profits, or take satisfaction in finding and owning the best companies, by your standards. According to The Forum for Sustainable and Responsible Investment Report on Sustainable and Responsible Investing Trends, one out of every six dollars under professional management in the United States is invested using SRI strategies. That’s a lot, and yet it’s not. Has it moved the needle on the social causes that matter to you? Perhaps if more investors pursued SRI, it would make a bigger difference in the world. At the least, it might lead to cheaper and more effective SRI investment products….

Performance

In the early days of SRI, the big concern was performance. Surely companies that were spending some of their resources taking extra care of their environment, communities, and employees would hurt their own bottom lines. Stock performance would suffer. There must be some cost for doing good.

But, the evidence is mixed.

Andrew Hallam, writing recently on building a low cost portfolio using socially responsible funds, cites two studies. One found that U.S. socially responsible investment funds underperformed conventionally managed funds from 1990 to 2001. But another found that the FTSE KLD 400 Index, which tracks the performance of socially responsible U.S. stocks, beat the S&P 500 from 1990 to 2012.

Investor’s Business Daily cites Morningstar data that the average socially responsible mutual fund has outperformed the broad stock market in the past 15 years, but notes that since the bottom in 2009, the broad market has risen 199% versus only 131% for socially responsible funds.

A study by Deutsche Bank Group found that incorporating environment, social and governance factors in investment analysis correlates with superior risk-adjusted returns.

In my opinion, you can believe what you want about SRI performance. This is a form of active management, after all. Performance is probably a function of the specific ESG filters employed. And it’s probably impossible to predict in advance. My own best guess is that performance differences between the broad market and SRI are probably not material, as long as you maintain a diversified, low-cost portfolio. And that is the real problem…

Expenses

The fatal flaw with SRI as it’s currently implemented in the mutual fund industry is not performance per se, but high expenses, which kill performance anyway. We have known for years now that high fees are the most reliable indicator of poor investment performance. And, frankly, expense ratios in the SRI industry are an embarrassment.

I used the USSIF Sustainable & Responsible Mutual Fund Chart, plus the mutual fund screener associated with my Schwab account, to research socially responsible mutual funds. There are hundreds of such funds available. And virtually none is cheap, by my standards.

For example, my investment portfolio has an average expense ratio close to 0.2%. By comparison, only a handful of SRI funds have expense ratios below even 0.5%. The vast majority exceed 1%. Some exceed 2%. And that’s before loads are factored in. Yes, that barbaric anachronism from the early days of the mutual fund industry is alive and well in socially responsible investing. You can buy some well-known SRI funds with loads approaching 5%. In today’s world, that’s a year or two of investment growth down the drain, before you even get started.

High costs are unnecessary and unbecoming to the SRI industry. It’s like finding out the executives at your favorite charity are getting rich off donations. Yes, I suppose that evaluating corporations against ESG standards is detailed work. (Though I wouldn’t be surprised if much of it was carried out by interns scanning newspapers.) But those ESG evaluations are a fixed cost. They don’t increase with assets under management, so why should fees?

The biggest threat to a socially responsible investment portfolio is not the performance of the underlying responsible companies. Enough studies now show those will perform competitively. No, the biggest threat is your do-good fund manager charging you 1-2% of your assets each year. That’s at least 25-50% of your available retirement income!

Most of us want to do good. But we aren’t willing to sacrifice our retirements to fat cats wearing white hats.

Low-Cost Alternatives

Diversification and low-cost are essential for retirement security. But it’s currently very difficult to build a well-diversified, truly low-cost portfolio of socially responsible mutual funds.

Among SRI stock funds, consumer-friendly Vanguard’s lone entry into the field, the Vanguard FTSE Social Index Fund (VFTSX), stands out. It sports an expense ratio of just 0.27%. But it’s not truly diversified. This is a large-cap growth fund of just U.S. stocks.

For international SRI exposure, a single entrant comes up on my radar: the Northern Funds Global Sustainability Index Fund (NSRIX). This is a global fund (about 44% international) that tracks the MSCI World ESG Index. Currently its net expense ratio is a mere 0.30%. It’s on my watch list, but due diligence is advised: This is a relatively new, small fund from a lesser-known mutual fund company.

Critical for retirees, there are no truly low-cost SRI bond funds, and no low-cost SRI balanced funds. The cheapest general-purpose SRI bond fund I can find is the Parnassus Fixed Income Fund (PRFIX) with a net expense ratio of 0.68%.

Is do-it-yourself SRI a possibility? Perhaps you consider certain sectors of the market to be inherently “responsible” — real estate, consumer staples, information technology, or municipal bonds? If you believe so, you could handpick sector funds or specific stocks and bonds for your investment portfolio. But that’s labor intensive, requires expertise, and would likely present diversification risk. It’s not a scalable retirement income solution for most of us.

When I retired, I was very interested in local investing. I looked at buying farmland or local small businesses. This could work for the right kind of investor. But it would have taken all of my time to manage. It would have tied me to one area of the country. And there would have been no blog, which I think is my true calling. Still, if your life is very focused on your local community, this could be a good solution for do-it-yourself SRI. Just be advised, if you concentrate all your wealth locally, you also expose yourself to geographic risk.

Our Solution

The modern economy is a complex beast. One that we all need to survive. And it defies simplistic labels of “good” or “bad.” Like most investors, I prefer that my investments be ethical. I don’t intentionally choose to own irresponsible companies in my index funds. But, like everybody else, I have limited time, energy, and knowledge for managing individual investments.

Years ago, I bought some iShares KLD 400 Social Index Fund. At the time, there was little to no data on the long-term performance of socially responsible investments, and I was unwilling to bet my entire equities portfolio on an SRI strategy. It was a small position. It was a distraction. And I closed it out in less than a year.

Now, a decade later, SRI choices have improved only marginally. You can’t give up diversification or pay high fees if you’re serious about frugal financial independence. But the majority of SRI products ask you to do that. Either you take on risk with a few cheap, imperfectly diversified funds, or you enrich investment managers, instead of the underlying social causes that matter to you.

Still, responsible investing is important to Caroline and me. We want to make a “down payment” on a solution. We are financially comfortable. There is no excuse not to move forward. So, what have we done?

A few months ago, we exchanged our Vanguard Total Stock Market Index Fund (VTSAX) for Vanguard’s FTSE Social Index Fund (VFTSX). That represents about 7% of our net worth, about 17% of our stock holdings. In doing so, we are taking on some risk, giving up small cap and value stocks. Though we do hold those in other portions of our portfolio.

So we’ve moved a non-trivial amount of wealth into the lowest-cost socially responsible mutual fund available. Like the human beings that create social problems in the first place, and the ones that create SRI’s in an attempt to solve them, this is an imperfect answer to a complex problem. But it’s a start.