Three years of bear markets and growing pension deficits have significantly accelerated and intensified the institutional search for out-performance. It is somewhat perplexing, therefore, that one potentially robust – and growing – source of alpha has scarcely been examined – at least not in a disciplined, sophisticated, and widespread way. That source? An analysis of companies’ performance and strategic positioning on environmental, social, and governance issues.
Why on earth should investors expect to find alpha in those areas? It’s quite simple: they are an increasingly potent proxy and leading indicator for the overall management quality of the firm, and their competitive and financial significance is increasing virtually by the month.
Historically, mainstream institutional investors have accepted unquestioningly the conventional industry ‘wisdom’ that the pursuit of environmental or social excellence in companies can only be achieved at the cost of lower financial returns for investors. As a result, the overwhelming majority of European pension funds have yet to exploit either the risk control or the demonstrated out-performance benefits of a rigorous analysis of their investment portfolios from this new, additional perspective. I believe that there are at least three major reasons for this:
o The deep-seated (but erroneous) belief that addressing social and environmental issues almost inevitably requires sacrificing risk-adjusted financial returns. (Quite the reverse has actually been proven true).
o The equally erroneous view that, since returns are “inevitably” compromised, fiduciary responsibility demands that social and environmental factors be set to one side when investment decisions are made.
o The ‘silent conspiracy of passive resistance’ by many pension fund consultants and asset managers, who are virtually unanimous in their indifference or even hostility to ‘socially responsible investment’ (SRI), and to whom most trustees are inexplicably deferential. Unfortunately, few if any of SRI’s critics in either group have taken the trouble to test the veracity of their assertions, either through their own original research or by consulting the growing financial literature in this area. (See, for example, the recent published work of Rob Bauer, head of research at ABP.)1 Old habits, it would seem, die extremely hard.
There is compelling evidence that these misconceptions have already imposed a substantial financial cost on European pension funds and their contributors and beneficiaries. What is worse, there is every indication that these investment risks are about to get even more serious. At least eight powerful, global ‘mega-trends’ can be expected to increase the ‘sustainability premium’ in the near future:
o Increasing empirical evidence of the nexus between companies’ performance on environmental, social, and governance issues and their competitiveness, profitability, and share price performance.
o Tightening national, regional, and global regulatory requirements for stronger company performance and disclosure of ‘non-traditional’ business and investment risks.
o Changing demographics for both consumers and investors, substantially increasing the saliency and financial stakes of companies’ environmental, social, and governance performance.
o The globalisation and intensification of both industrial and institutional investment, particularly into emerging markets. This exponentially increases the level of risk for both major corporations and investors from these new, ‘non-traditional’ factors.
o Growing pressures from international non-governmental organisations (NGO’s), armed with unprecedented resources, credibility, and global communications capabilities and a keen interest in companies’ performance on environmental, social, and governance matters.
o A substantial broadening of the purview of what is considered to be legitimate fiduciary responsibility to include companies’ performance in these areas.
o A growing appreciation by senior executives of the competitive and financial risks and benefits of sustainability factors.
o A growing inclination – and capability – among major institutional investors for shareholder activism in the governance of their portfolio companies on these issues.
As a result of these powerful mega-trends, the ‘prudent fiduciary’ equation is now – quite properly – being turned on its head: fiduciaries are increasingly seen as derelict in their duties if they do not consider environmental, social, and governance risk factors in their investment strategies. The recent revisions to pension laws in the UK, France, Germany, and other European countries make this abundantly clear.
Climate change, for example, provides a perfect example of the convergence of fiduciary/corporate governance imperatives with the ‘sustainable development’ agenda. Recent research by Innovest Strategic Value Advisors and others has revealed variations in the climate-driven financial risk exposures among major companies in the same industry sector of up to 30 times! It seems to me that it behooves any prudent fiduciary to know which company is which before investing millions of euros of someone else’s retirement savings in one or the other!
Going forward, it seems clear that such ‘intangible value drivers’ as environmental, social, and governance performance can, must, and will be analysed and quantified with increasing rigour and sophistication by mainstream analysts and asset managers. After all, there is a limit to how long even the most stoical investors will tolerate analysis which wilfully ignores as much as 30-40% of companies’ true risk profile and value potential – and loses them bucketfuls of money into the bargain. Given the serious and ongoing challenges confronting pension fund finance in Europe, prudent fiduciaries should be clamouring for some serious action.
Matthew Kiernan is chief executive officer of Innovest Strategic Value Advisors and is based in Toronto
1 Bauer R et al: ‘The eco-efficiency premium in the US equity market (2003)’; ‘International evidence on ethical mutual fund performance and investment style’ (2002)

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