What is Wrong with Moral Investing and How can it be done better?

By David G. Bjornstrom

Much has been written about the morality of investing in the stock market, often expressed in terms of an obligation to avoid stock in companies that are engaged in immoral businesses. This can be very difficult considering the wide variety of business activities of major corporations and the diverse stock holdings in modern mutual funds, but fortunately Catholic moral tradition does not hold us to an impossible standard.

“Formal” vs. “material” cooperation

The Church distinguishes between “formal” or intentional cooperation in another’s evil, which is always wrong, versus “material” cooperation, in which we make it possible for someone else to do evil but without intending it ourselves.

Material participation in another’s evil may or may not be culpable depending on circumstances. This includes the degree to which the bad results are avoidable and also the possible countervailing considerations that might warrant accepting the bad side effects.

This may apply to stock investments that include a small, inadvertent stake in companies doing some bad things.

Put another way, stock investment in companies that do some bad things would generally be considered indirect material cooperation, which may or may not be culpable depending on what other options are available and possible countervailing considerations that might justify accepting the bad with the good.

The bottom line is that a Catholic investor should make reasonable efforts when possible to avoid stock in companies engaged in immoral businesses.

How does a person morally invest?

An individual investor can attempt to do all the research necessary to exclude bad stocks from his portfolio, but that is not realistic for most of us.

There are Christian investment managers who design mutual funds and private investment accounts consistent with moral principles, generally by screening out stock in companies engaged in “immoral” business practices, including abortion, pornography, bad employee practices or anything else contrary to the investors’ moral beliefs.

But while many of these “customized” investment vehicles make a valiant effort, even the best are lacking in some key areas such as:

1. Many investor accounts are held in company retirement accounts (e.g. 401k’s), pensions or other investment vehicles with limited investment choices, generally not allowing them to be invested in morally screened accounts.

2. Morally screened accounts are often tilted toward large capitalization US stocks, causing them to miss out on some major investment sectors like small and mid-cap stocks and foreign companies which can be much harder to screen than large US corporations.

3. Investors with substantial unrealized capital gains in their existing accounts may be reluctant to move to a morally screened account since that would require selling the “immoral” stocks and paying tax.

4. Some investors have the ability to move their accounts but simply wish to stay with their current manager who does not do moral screening. 

5. Costs are significant as well. Moral mutual funds and privately managed investment accounts often have relatively high management fees, being actively managed with an extra layer of research and analysis required to screen out bad companies. They cannot generally use low cost index funds since the indices include some bad companies. 

The big question remains

Considering the moral obligation to minimize bad investments, is there any way for an individual investor or investment fund manager to use a traditional diversified portfolio but neutralize the effect of the immoral stocks that are inevitably a part of it?  

One answer is to take a “short” position in some of the most immoral stocks. 

What is shorting and how could it help?

In a nutshell, “shorting” (taking a “short” position) is the opposite of buying a bad stock.

Through modern computerized stock exchanges, the investor effectively borrows the immoral stock from someone else in order to sell those shares.

If we estimate, for example, that a traditional mutual fund or managed account includes 5% immoral stocks, an investor could “short sell” the worst of those companies separately from the fund, essentially neutralizing the 5% immoral position.

This is traditionally done to make money on stock that the investor hopes will go down in price, but shorting can be done just as well for moral purposes in order to create a sale of bad stock that would not otherwise occur.

What if shorting isn’t possible or prudent?

But what about the fact that a typical portfolio holds numerous small positions in immoral stocks, making it extremely difficult or impossible to identify and short all of those?

This problem can be addressed by shorting just a few of the worst offenders (equal to 5% of the fund in my previous example) in lieu of shorting each and every bad stock. By focusing on some of the worst companies, the moral investor is actually taking a stronger position than if he took just a small short position in numerous bad stocks.

The investor might even decide to short some exceptionally vile companies that are not even present in his own portfolio. Granted, the investor will still own his regular portfolio with the 5% immoral element, but he will have an off-setting short position in the worst of the worst, resulting in zero percent net ownership in immoral companies.

An advantage

This shorting concept is not a perfect solution, but it has one tremendous advantage over existing so-called “moral investment funds”. It allows the investor to keep an unscreened portfolio that he cannot or doesn’t want to sell, including small cap and international mutual funds, low cost index funds, stocks with unrealized capital gains, investments managed by a longtime trusted advisor, or a company retirement account with limited investment choices. 

The investor will offset the bad stocks with an equal short position in similar bad stocks. Even if the shorted stocks are not exactly the same as those remaining in the investor’s traditional portfolio, the shorted stocks will be as bad or worse on average.

Possible objections

Some may object that this shorting technique doesn’t fully solve the moral problem since the investor will still own bad stocks even though they are counterbalanced by the short positions. While that is true, the short position is a true offset as far as the stock market is concerned. It creates an actual sale of “borrowed” shares in the bad company.

Again, Catholic moral teaching does not say it is inherently wrong to own stock in a company that does some bad things, so long as the investor does not intend the evil itself and he makes reasonable efforts to minimize his participation.

From an investment diversification standpoint, it could be objected that the 5% short position in immoral companies will offset 5% of the investor’s “long” position in his traditional fund, causing him to miss that component of a diversified portfolio.

However, the investor, if he wants, can restore that diversification by purchasing an equal “long” position in similar company stocks that are not immoral, hopefully companies that are as highly correlated as possible to the shorted stock.

For example, a short position in a hospital company that performs abortions could be balanced out by adding an equal “long” position in a moral health care stock. This is not unlike existing “short-long” mutual funds but, in this case, done for moral purposes rather than attempting to beat the market. Intention matters here.

It might also be objected that the offsetting short and long positions leave the investor with a “neutral” stock component in his overall portfolio, effectively taking that portion out of the market.

While that is true, the neutral portion is relatively small, representing just the percentage attributable to the bad stocks, often no more than the cash position in a conservative portfolio. The short position is similar to a small “hedged” stock position, which may be a very good investment decision in a volatile stock market.

The investor will lose money on his short positions if the stock price goes up, but that would generally be offset by a gain on the long positions still in his account. The opposite would occur if the price of the shorted stock goes down, namely a gain on the short position with a likely corresponding loss on the long positions.

Again, the short is essentially just an offset to the bad stocks remaining in the investor’s account, allowing him to keep the account while cancelling out the immoral component.

Obviously the shorted stock and the remaining long positions will not be perfectly correlated, so there is a risk if the market goes up that the investor could lose more on the short position than he gains on his long positions, or if the market goes down he could lose more on the long positions than he gains on the short. However, there is just as much chance that he will come out ahead if the relative stock price changes work to his advantage.

The investor, of course, will hope that the bad stocks go down in price (making money on the short positions) while his good stocks go up in price.

What am I suggesting?

Catholic investors should recognize this as a real moral issue and make some effort when possible to minimize or offset their stake in bad companies, including by the use of short sales when appropriate.

Investment researchers can assist by identifying and publicizing the names of bad companies to be avoided or shorted and good companies in similar industries to take their place.

I would encourage Catholic investment professionals and mutual fund managers to continue what they are doing, but also to develop practical approaches and new investment products—including morally hedged funds with short sales of bad stocks—that could be attached to an investor’s regular portfolio.

What do you think about the matter? 

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David G. Bjornstrom is a Santa Rosa, CA-based attorney at law with 36 years specializing in business, estate and tax law. He may be reached at David@CatholicBusinessJournal.biz

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