Using funds to catch outperformance
Establishing a commitment to SRI standards in investment policy is just the first step. How then to apply this in the context of institutional investment policy? In the same way that no two hedge funds are alike, the SRI funds market is complicated by the different ethical boundaries that each fund sets. A report published by the New Economics Foundation (An ethical door policy – how to avoid the erosion of ethics in SRI) suggests that, for the SRI sector, this looseness represents considerable risk to the credibility of the concept: “throughout the SRI range, there is a lack of a well-developed framework for comparison of SRI products”.
The emergence of ethical investment benchmarks suggests that it won’t be too long before we see more clearly defined sub-sectors. It is open to question whether the still fluid state of SRI benchmarking is actually a bad thing, in view of the fact that fund managers are forced to think more clearly about their own investment strategy when guided most strongly by the underlying SRI selection criteria.
The NEF paper agrees it could be argued that the absence of standards encourages funds to compete on the quality of their ethics. But it concludes that: “in practice, this is not what is happening”. The implication is that fund managers are too passive – simply screening out companies rather than engaging them.
The creation of an SRI code of conduct by the Dutch association for the sustainable development, VBDO, addresses this very point. The express intention of the code is to increase the transparency of their investment policies. The association is made up of 20 Dutch financial institutions, including ING, ABN Amro and Rabobank. The code requires funds to explain on request why they have excluded a company on social or environmental grounds – which could be difficult for firms that offer funds based on SRI indexes such as DJSI and FTSE4Good. It calls on SRI fund managers to disclose:
o composition of their portfolio;
o changes in composition, and the reasons for exclusions and inclusions;
o the resources, methodologies and research agencies used;
o information about the research used; and
o how they ‘engage’ with companies on environmental and social issues.
The initiative is now being pushed for adoption within the European Social Investment Forum.
The Swedish government’s Mistra Foundation notes that since SRI funds first appeared, the sophistication of stock selection techniques has increased markedly. In particular, the decreased importance of negative screens and the rise of positive stock selection with a focus on ‘best in class’ companies in any given sector has allowed SRI managers to more easily marry financial and social requirements. Most fund managers will still exclude sectors that are inherently outside the scope of SRI, such as tobacco, armaments and pornography.
At this stage in its development, it is certainly questionable to what extent SRI asset managers are effectively ‘engaged’ with their companies. It’s a question of scale and it is at least encouraging to note that the larger ethical investors, the likes of Henderson Global Investors and Friends Provident, are operating an engagement policy that reviews social and environmental risk across their full portfolio, representing £100bn (e150bn) and £13bn respectively.
The NEF paper is particularly sceptical of the effectiveness of the fund management activism: “Typically, SRI funds claim legitimacy by appointing ‘committees of reference’ or using recognised consultants to do the screening. Neither is an effective route to raising quality. As of now, SRI research screening is a consultancy business, subject to the usual conflicts of interest, rather than a profession governed by standards. Well-meaning names on a committee are no substitute for real dialogue with the key stakeholders of SRI, including investors themselves.”
The report published last November by CSR Europe and Avanzi SRI Research (SRI funds strategies and operating conditions) is a little more charitable to the fund management industry. It confirms that the level of discussion and activity varies from case to case, but by assessing a wider range of fund types across Europe, it acknowledges some interesting trends in the area of outsourced committees: “They produce a more tangible effect on investment decisions. The most interesting case is represented by two funds, the Dexia Stimulus Balanced Medium Fund and the Fortis Alter Vision Fund, that invest in stocks within the Ethibel label register.”
The Mistra Foundation published a report in 2001, which set out some ‘best practice’ ideas for SRI and included a survey of available investment products. The key characteristics identified by Mistra were:
o triple bottom line
o focus on ‘best-in-class’ and pioneers/innovators
o evaluating sustainability opportunities and risks
o intelligent screening (combining quantitative and qualitative analysis)
o qualified research team
The Mistra survey concluded that the major problem related to SRI-screening is the availability of relevant and accurate information – and the availability of qualified research teams: “The capacity to analyse companies’ social/environmental performance could be improved if the SRI-screening models used – and the key results of the screening processes were more openly presented. Focus should preferably be on key performance indicators in different business sectors – and presentations of best-in-class companies to highlight key issues. A more open attitude – focusing on best-practice – would facilitate a process to improve the quality of SRI products. Furthermore, over the longer-term, we are convinced that openness also accelerates the introduction of key sustainability issues into the more traditional financial analysis models used in the financial community.”
When we come to assess the funds themselves, it is not easy to confer a preference on the basis of performance, since none of the funds has been going long enough to have benefited from a bull market. In relative performance terms, if we use the Standard & Poor’s offshore funds universe, the range of funds includes only four with a star-rating and none of those has produced anything conclusive. The best performer is the $4m Luxinter Ethifond from Van Moer Santerre & Cie in Brussels, which has outperformed the sector by some way during 2002. The only funds of significant size that get an S&P rating are Credit Suisse Lux Sustainability B Fund and the SAM Zurich Sustainable Index Fond.
Most of the branded funds are less than $10m in size which means they are essentially retail funds. The CSR/Avanzi report also notes that SRI managers often struggle to gain recognition within their own firm and this can be particularly difficult for the manager of a small fund that will have higher running expenses than larger funds in the same group and the manager will therefore need to beat internal rivals on performance in order to gain credibility.
Performance comparisons suggest that SRI portfolios will marginally outperform in a healthy bull market environment, but may underperform in more bearish conditions. Current research material seems to suggest that performance is a secondary consideration to ethics, but the outcome would be different if the question were addressed at pension fund trustees rather than SRI campaigners.
The weighting given to financial and SRI considerations is one aspect that varies between funds. In several funds, the SRI analysts first draw up a list of approved companies from which the fund managers then select those that meet the appropriate financial criteria. Other SRI funds are managed effectively in reverse order, with the primary analysis being conducted by fund managers and companies initially being selected on the basis of their financial performance.
There is a genuine prospect though that future long term returns from SRI could be higher than for the market as a whole, because if sustainability and environmental responsibility become the norm for business, then those companies that adopt such standards will be the sunrise industries.