One of the deterrents of environmental, social and governance (ESG) strategies is the perception of missing out on returns when investing in them.

But the performance of the £255m (€356m) F&C Asset Management’s Stewardship International fund and the $35m (€23.8m) HSBC Global Merit SRI Life fund suggest that such worries are unjust. Both global equity funds have outperformed since inception their mainstream benchmark, the MSCI World Index.

The main reason for the funds’ outperformance appears to be stock picking.

“Our geographic and sector allocation is a result of our bottom-up stockpicking,” says Terry Coles, co-manager of the Stewardship International fund. “This means we assess each company based on its own merits, and macro considerations are not the primary focus, yet, we have to be aware of the benchmark and diversification and would not, for example, invest 100% in emerging markets.”

The stocks in the HSBC Global Merit SRI Life fund are determined by two processes, according to Xavier Desmadryl, global head of SRI research at HSBC Investments. The first is Innovest’s socially responsible investment (SRI) screening. The second is the Sinopia asset management’s multifactor enhanced return investment technique (Merit).

“We do not take large sector or country positions against the benchmark,” says Nils Jungbacke, head of enhanced index strategy at Sinopia. “Instead, we focus on taking positions at the stock level and take many small active positions against the benchmark. And we select the stocks to take those positions by using two quantitative signals in the Merit process, which can be described as valuation and momentum.

“For valuation we look for companies that are cheap relative to their peers, while for momentum we look for companies that had their earnings forecasts upgraded by analysts over the previous few months as well as companies that have performed well over the previous year in terms of price appreciation.”

Jungbacke adds: “Innovest helps us to screen the initial universe of 1,900 stocks to around 600 socially responsible but sector-neutral policies. Then we apply our quantitative screen valuation and momentum and overweight the high-scoring and underweight the low-scoring companies, which leaves us with around 200 stocks in the fund. It is this process, that is largely responsible for the outperformance. There is no minimum or maximum but we need to hold a certain number of companies to keep the tracking error of the fund in the target range of 1.5-3% against the benchmark.” Managing the risk against the MSCI World mitigates the risk and volatility of the fund, Jungbacke explains.

But not all SRI funds can remain close to the benchmark. F&C’s Stewardship funds, for example, seek to invest in companies that make a positive contribution to society. This means that it is excluded from owning most energy stocks; instead the fund has a large overweight to non-traditional or renewable energy. It also boasts a 12% and 8% overweight to IT and emerging markets respectively, as well as a significant underweight to financials - around 10% versus 22% in the benchmark - and large-cap pharmaceutical companies.

“Our large overweight to non-traditional energy can boost the fund’s performance but it can also hurt,” says Coles. “The strong run in the solar sector, for instance, reversed sharply at the end of the second quarter of 2006 due to silicone supply problems, while traditional energy, large-cap pharmaceuticals and material stocks like the mining sector - most of which we are unable to invest in - were good performers.

“However, since then we have had a very strong performance, which means we are again ahead of the benchmark. This demonstrates that the fund’s short-term volatility tends to even out over the longer, six-to-12-month term. At just over 4.2% the fund’s tracking error is very low.”

Recent good returns stemmed from direct investments in alternative energy, mainly the solar sector, which correlates with the oil price. But even a sharp fall in oil price would not be disastrous for the fund, according to Coles, as it is diversified across all sectors including IT, utilities, telecoms, financials, medical equipment and consumer discretionary.

Although the fund was largely unaffected by the subprime crisis due to its underweightings in financials, it did feel some impact - Countrywide Financial and, particularly, Northern Rock which was one of the few financial stocks deemed acceptable for diversification reasons. The stocks have long been sold.

“We are valuation-focused and we consider the valuation relative to the company’s global peer groups but also use a proprietary economic value added (EVA)-based model,” says Coles. “And it is the combination of these two approaches that helps us determine whether the stock is attractively priced or overvalued. If we see a short-term valuation opportunity combined with a strong fundamental outlook we will be opportunistic and add a position to our fund. We typically submit 30-to-40 stocks a quarter to our in-house governance and sustainable investment (GSI) team for screening. Our universe now exceeds of 1,300 stocks, up from just under 1,000 a year ago, with the fund’s stocks typically ranging between 90 and 110.

“Over the last couple of years, the valuation approach has become more robust. Indeed, stock selection and diversification across sectors and a focus on downside risk have driven performance and helped curb volatility and risk over the longer term.”

A recent study by Munich-based rating agency, oekom research, revealed that its prime universe - currently containing around 250 global, sustainable mid- and large-cap equities - had returned a total gain of 35.8% over the past six years compared with MSCI World’s negative 24% yield calculated in euros in the same period.

Benedikt Rauch, analyst at oekom research, says the outperformance may be attributed to the large number of European companies contained in the prime universe while US firms comprise almost half of the MSCI World index’s weight. But he stresses that the study does not deliver an explanation.

While oekom research’s prime universe does not screen out sectors, bad ESG behaviour leads to a lower rating, which diminishes the probability of a company being included.

“Through the best-in-class approach and exposure to all sectors we mitigate the risk of volatility,” says Rauch. “However, volatility does not necessarily damage the performance.”

“Our fund is the clear evidence that SRI funds do not structurally underperform,” says Desmadryl. “By concentrating on a limited number of stocks with overall positive characteristics, you will be able to at the least have the equal returns of, or outperform, a mainstream fund over the mid-to long-term”.

And Desmadryl points to a study undertaken by the Asset Management Working Group of the United Nations Environment Programme Finance Initiative (UNEP FI) - of which he is co-chairman - with investment consultancy Mercer. The review of key academic and broker research on ESG factors called ‘Demystifying Responsible Investment Performance’ says that of 20 academic studies reviewed, 10 revealed a positive relationship between ESG factors and portfolio performance, while seven revealed a neutral and three a negative relationship. The report concludes that, according to the evidence presented, there appeared to be no performance penalty for taking ESG factors into account in the portfolio management process.

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