From niche to financial norm

 

In the past few years, socially responsible investing has attracted a loyal following in the European investment community. However a new report notes that SRI is no longer considered just a specialist activity. Increasingly, mainstream fund managers are incorporating social and environmental factors into their portfolio considerations.

According to Julie Hudson, CFA, author of ‘The Social Responsibility of the Investment Profession,' and managing director, head of socially responsible investment equity research at UBS in London, "In the past, when people heard the acronym SRI, they often thought of a niche area. That is changing and there is a realisation that the information and insights produced by SRI can potentially be relevant to financial markets and those making general investment making decisions."

Take climate change. It has moved out of the environmentalists' domain and onto the national stage. Hudson explains, "Three years ago, climate change was only being looked at by those fund managers in the SRI world but they helped bring the issues to the attention of the markets and wider public.

Over time there has been an increase in scientific information and most recently new regulation such as the Emissions Trading Scheme (ETS) in Europe which aims to reduce greenhouse emissions. As a result, today, it is on everyone's agenda. I would be surprised if fund managers in general were not looking at climate change in terms of oil prices as well as which companies were producing the most effective renewable energy technology solutions."

Hudson's monograph, which was commissioned by the US based Chartered Financial Analysts Institute's research foundation, is the latest in a CFA publication series highlighting relevant research topics. The publication does not advocate SRI, but aims to educate institutional investors about the intricacies of the investment philosophy. This includes explaining the different portfolio strategies, the interpretations by certain countries, and the impact on financial markets and returns.

Hudson also endeavours to demystify the world of SRI. It is like an alphabet soup of terms and phrases- SRI, CSR (corporate social responsibility), EFI (extra-financial issues), ESG (environmental, social, governance), triple bottom line investing, and the list goes on. This can create a certain amount of confusion but in many ways there is really is no difference between the objectives of the SRI and non SRI fund manager. The most important people in both cases are the end investors in managed funds, their needs, return requirements, risk appetite and any constraints. "At the end of the day, the goal is to deliver the best possible expected returns given the investor's risk profile and constraints, of course including any relevant values-based constraints."

According to Hudson, in the SRI milieu, there are typically four main value based drivers - ethical or faith based beliefs, social movements often motivated by political attitudes or reactions against political regimes, and a specific catalyst such as war, disease or famine which can elicit a strong emotion.

Last, but not least, is the corporate governance structures a company adopts. Hudson notes this is because these polices are an indication of how a company handles its social, environmental and ethical issues. This ranges from its relationships to shareholders, employees, suppliers and customers to the direct impact it may have on a community or on the environment. From an investor's view, it will provide an insight into the company's strategic direction and risk control.

Hudson also points out that when analysing companies, investors must realise that there is no standardised CSR format. The US, for example, takes a so-called agency view which prescribes to a combination of legislation such as Sarbanes Oxley that calls for financial accountability as well as voluntary codes to keep companies in line.

The UK adopts a principles based ‘comply or explain' approach which among other things emphasises transparency, auditing, stringent controls and open communication with shareholders.

Regulation and voluntary codes are also a feature. France, Germany and Japan, on the other hand, are often described as having "insider" systems whereby majority shareholders, institutions and employees wield considerable sway over a company's movements. Just as companies have different CSR structures, fund managers also have varied investment styles reflecting their countries' regulations, cultures, laws and norms. "Although SRI can be described as global, it is also local. The specific mix of portfolio approaches and the relative importance of other forms of social investment, such as community involvement and philanthropy, vary considerably," says Hudson.

Broadly speaking, there are four or five different globally accepted strategies - exclusion screening, best in class, engagement and activism. Thematic investing has also grown in popularity in the SRI as well as mainstream space.

"I did not include this approach in the monograph, but I would now as more and more SRI fund managers are attempting to choose companies that have products or solutions that address a particular environmental or social issue. This could range from new, affordable drugs for people suffering from HIV Aids in Africa or products that offer alternative energy solutions to offset the problems of climate change."

Breaking down investment philosophy on a geographical basis, Hudson notes that over three quarters of SRI funds under management in the US prefer to operate under the screening or exclusion banner. The Dutch are the same although the SRI market is still evolving as investment houses increasingly take a more proactive stance. Exclusion screening suggests that investors, as a fragmented group, believe they have little power, at least in the short run to influence individual companies or financial. Instead, they avoid certain companies and industries such as defence and tobacco on the basis of qualitative criteria.

Exclusion by large number of investors in a high profile fashion can translate into a form of activism and have a direct impact on companies. Although it took time, South African and tobacco investment exclusion policies did eventually take their toll. However, generating alpha is not the aim of the fund manager adopting this approach. Instead, investors in this category are willing to sacrifice returns for their beliefs, and the hope that in the long run, companies will change direction.

The French and British are proponents of the ‘best in class' screening process. This involves ranking different peer companies in a particular sector according to their environmental, social, governance and ethical as well as financial performance. These portfolios are not benchmarked against a specialist SRI benchmark but against conventional benchmarks. The goal is to have a diversified portfolio which generates strong performance over the long run.

UK fund managers favour mixing the best in class style with engagement whereby shareholders engage in constructive dialogue with the top brass. The portfolio is less diversified but this is offset by the belief that a closer relationship with management can enhance returns and reduce risk over the long term.

As for SRI and fund returns, companies behaving ethically and incorporating CSR issues within their corporate strategy does not guarantee superior returns. Hudson explains that there are many widely held and contradictory beliefs concerning performance.

Some feel that the application of SRI strategies does not make a difference, to either return or risk in the short term while others see it as a cost in risk adjusted performance terms. There is also the view that SRI can yield superior risk adjusted performance because firms that generate strong returns in environmental and social terms are simply strong performing companies.

"The big question to ask is whether active asset management in general generates superior returns. There has been a lot of work in this area and the research has been inconclusive. In some cases, the answer is yes and in others, it is no. There is no reason to believe that SRI would be any different. It is also important to remember that the performance and risk profiles of the portfolio will also depend on which specific approach to SRI the fund managers adopt."

Despite the uncertainties, Hudson believes investors overall can glean a great deal of information about a company by looking at the way it navigates through and manages ever changing regulatory barriers and different stakeholder relationships, whether they be shareholders, suppliers or employees.

Applying a SRI lens often sheds light on those companies who have strong management and internal controls and the firms who are buckling under the burden and cost to comply with new laws or guidelines.

For example, energy and industrial companies who have successfully implemented new legislation may find themselves off the exclusion lists.

The same view may apply to retail companies who were once shunned for shoddy supply chain methods but have caught a conventional fund manager's eye with their improved practices.

As Hudson notes, "Too often, people think of SRI in terms of risk but it also highlights the opportunities. New regulation or disclosure requirements can level the competitive playing field so it's useful to identify those companies who are already handling the issues most effectively because they are likely to perform best in the presence of the new rules."