Is 'not so bad' a good investment?

For three decades, investors keen to build a better world have grudgingly held stocks in less-than-perfect industries. Owning shares, they've hoped, would afford them two good things: solid performance via diversification and an insider voice to encourage best practices at firms that just might listen.

But activists say too little has come of this "best in class" approach, which supports the least-bad actors in a range of industries from oil and gas to mining. New portfolio research suggests the strategy might be overrated.

"There is more of a challenge being applied to best in class" as a strategy, says Ominder Dhillon, head of distribution for Impax Asset Management, a London-based firm. "In a low-growth world, are all sectors going to generate growth in similar amounts? I don't think so. So we have to focus our efforts on those areas that have the best prospects."

As best in class faces fresh scrutiny, a longstanding pillar of socially responsible investing (SRI) is being questioned. Stakeholders are asking whether investors need exposure to all major sectors, even problematic ones, and what difference those investments really make.

Among the factors driving this reexamination is a new push for divestment from environmental activists. Nearly 500 local campaigns have cropped up to urge governments, religious institutions, and other institutional investors to phase out their fossil-fuel holdings, including equity shares and bonds issued by some of the world's largest blue-chip companies.

Proponents of best in class say the method is as effective and important as ever. It's commonly used in SRI mutual funds. The Legg Mason Social Awareness Fund, for example, has had at least six oil industry holdings this year, including Apache Corp. and Schlumberger Ltd., among its top 20 holdings. The fund has latitude to invest in any industry, even weapons manufacturing, as long as analysts deem a stock ranks higher than its peers on social or environmental benchmarks.

Best in class has a financial raison d'être: performance. Portfolio theorists agree diversification helps mitigate risk. A portfolio that shuns particular sectors in the name of social responsibility theoretically runs higher risks – though not necessarily much higher – than one with broad market exposure for weathering ups and downs.

"The basic story that one needs to have a well-diversified portfolio hasn't changed," says Christian Lundblad, a finance professor at the University of North Carolina at Chapel Hill. "People still buy in deeply to that argument, and the research hasn't altered at all."

New studies suggest, however, that the upside to owning all sectors can be small and is sometimes offset by sector-specific risks. For example, dropping exposure to small controversial sectors – such as tobacco – doesn't devastate portfolios, according to research from Aperio Group, an investment management firm in Sausalito, Calif.

It's riskier to eliminate large sectors of the economy, such as energy or financials, according to Aperio Group's chief investment officer, Patrick Geddes. But many risks can be managed, Mr. Geddes says, by overweighting elsewhere to compensate for what's been removed, such as by increasing exposure to comparable large cap international stocks in other industries. Hence investors need not assume they must have exposure across the board.

"Best in class is a blunt instrument. It's too rigid," Geddes says. "The focus should not be on the simplistic idea of 'Don't we have to hold every industry?' but rather on 'What incremental risk am I introducing with any of these screens?' Just measure it."

Best in class is rarely, if ever, used by American colleges and universities, which are managing more than $400 billion in endowment assets, says Mark Orlowski, executive director of the Sustainable Endowments Institute, a Cambridge, Mass., nonprofit that encourages impact investing. For them, "it's really about, 'Either we invest for best return regardless of [SRI] criteria, or we engage [in dialogues] with the companies we already own, or we consider divestment.' "

When Impax looked at the effects of removing fossil fuels from a portfolio, it found five-year performance actually improved by 10 to 50 basis points, depending on management style and whether renewable energy stocks were added. Because some sectors like carbon-intensive energy carry specific risks, investors might do better to avoid them than to seek exposure everywhere, Mr. Dhillon says.

MSCI, a New York indexing, analytics, and portfolio risk firm, found a bump up of 70 to 80 basis points by excluding fossil-fuel holdings over the period between January 2008 and March 2013. Nevertheless, broad market exposure, reflected in a best-in-class approach for SRI investors, remains important for ordinary investors who can't afford to miss out on sectors that outperform, sometimes unexpectedly, according to Jennifer Bender, vice president for index research at MSCI. "Walking away from certain sectors is ... affecting your long-term return. You definitely want to have a balanced [approach] across sectors."

In terms of working toward a better world, best in class gives investors a voice within companies that have the resources and reach to have significant effect, according to Laura Berry, executive director of the Interfaith Center on Corporate Responsibility, an institutional investment center in New York.

It doesn't always work. SRI funds roundly praised BP for pioneering solar energy and other renewables, until BP presided over the massive 2010 oil spill in the Gulf of Mexico, she notes. Still, it's crucial for investors to be at the table with major industry players.

"Who has the funding and the bandwidth to actually make a difference?" Ms. Berry asks. "Who underwrites academic research? Who spends lobbying dollars in the United States to influence regulations? I would argue that best-in-class investing ... is going to influence" companies with enough heft to deliver large-scale changes.

Lobbying hard for better practices would be great, critics say, if that's what SRI funds really did. Too often, they merely hold positions in companies deemed to be more responsible than their peers, or they press for disclosure reports that track – but do nothing to change – environmental or social transgressions. That's according to Michael Kramer, a Hawaii-based managing partner at Natural Investments, a financial planning and investment advisory firm that rates SRI funds and gives mediocre marks for many that use best in class.

"Disclosing how you're destroying the world doesn't stop it," Mr. Kramer says. "It doesn't go far enough."